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2. The term „hedge fund“ applies to a fund that is privately managed, limited to a select group of

investors, and is subject to a very low level of regulation.

3. The private nature of hedge funds and the selectivity of clients lead to low regulation, making

hedge funds distinct from mutual funds, which are heavily regulated, publicly traded, and

available to all investors.

4. Hedge funds usually focus on absolute return, as opposed to mutual funds which focus on the

return relative to a benchmark.

5. Hedge funds pay a fee to the manager as a percentage of profit or asset appreciation, while

mutual funds usually pay a percent of assets under management to the manager.

6. Hedge funds often have redemption limitations which require a minimum investment period

and some pre-specified amount of warning time before an investor can withdraw capital.

7. Hedge funds using the tactical investment style take positions designed to benefit from

movements of entire markets such as bonds, equities, currencies, and commodities.

8. There are two main sub-styles in the tactical investment style: global macro investing and

commodity trading advisors.

9. The global macro strategy makes opportunistic tactical moves in global markets. Each fund is

usually concentrated in one area and may use a variety of strategies (e.g., derivatives and

leverage).

10. Commodity trading advisors, or CTAs, generally trade listed financial futures and commodities

for their clients.

11. CTAs may be discretionary traders or systematic traders. To make trading decisions,

discretionary traders use fundamental and technical analysis and their own personal trading

experience, while systematic traders rely more on historical relationships incorporated into

computer programs.

12. The equity long/short style refers to taking both long and short positions in equities. Most

funds using this style have a net long exposure to stocks, but some funds will take

comparatively large short positions.

13. The equity long/short style has three style categories:

• The dedicated short selling style.

• The emerging markets style.

• The market timer style.

14. The dedicated short selling style only takes short equity positions.

15. The emerging markets style attempts to gain from the low level of information and

idiosyncratic movements associated with those markets.

16. The market timer style takes positions based upon short-lived factors.

17. Event-driven styles generally focus on securities associated with companies where a major

event like bankruptcy, a merger, or a spin-off will occur.

18. Three general event-driven style categories are:

• The distressed securities style.

• The merger arbitrage (or risk arbitrage) style.

• The event-driven multi-strategy style.

19. The distressed securities style focuses on assets of distressed companies where the manager

thinks the assets are severely undervalued.

20. The merger arbitrage style focuses on potential profits associated with a merger or acquisition.

21. The event-driven multi-strategy style can use the distressed securities style and/or the merger

arbitrage style. It can use both at the same time or switch back and forth. The style also

includes the use of other strategies such as investing in micro-cap stocks.

22. The relative arbitrage style takes positions in two securities, usually with an identifiable

relationship such as convertible bond and the associated stock, that are mispriced relative to

each other. The goal is to gain when the securities converge to their appropriate values over

time.

23. Arbitrage is the process of the two securities converging to their appropriate market value.

24. The convertible arbitrage style involves taking a long position in a convertible bond and selling

short the associated stock.

25. The main source of return of the convertible arbitrage style comes from a decline in the price

of the stock. The main risk is from the possibility of the stock increasing in value, but this is

hedged with the bond’s embedded option, which is generally believed to be undervalued.

26. There are many fixed income arbitrage strategies. To earn profits, they can use tax loopholes,

different laws and taxes policies around the world, projected changes in yield curves around

the world, and other factors. Often, the manager will create the position and take offsetting

positions to neutralize interest-rate risk.

27. The equity market neutral style uses a long/short strategy and has a stated goal of eliminating

market risk (i.e., reducing beta to zero), with offsetting long and short positions.

28. Usually, an equity market neutral manager uses pair trading, which involves buying one stock

that is undervalued and one that is overvalued, in proportions that result in a beta equal to

zero. The main source of return comes from corrections of the asset prices.

29. In contrast to the equity market neutral style, the equity long/short style takes short positions

but does not explicitly try to set market risk equal to zero.

30. The index arbitrage style generally attempts to exploit mispricings between an index and its

associated derivatives.

31. The mortgage-backed securities arbitrage style seeks to earn a profit from mispricing of these

assets, relative to Treasury securities, based upon their uncertain credit quality and

prepayment risk.

32. A fund of funds will allocate capital to different managers of hedge funds who may or may not

use the same style. The goal is to diversify across managers and/or styles.

33. In contrast to a fund of funds, a multi-strategy fund tends to have the capital under the

management of one person or office. It may use many styles, which can provide some

diversification, but it may focus more on trying to time the styles.

34. High net worth individuals are currently the main source of the assets under management for

hedge funds.

35. Institutions are expected to be a major source of capital for hedge funds in the future, but

individuals will continue to supply capital.

2. Measuring Return

1. The lack of transparency in the hedge fund market is caused by several factors including the

fact that they are privately organized, regulations restricting hedge fund marketing, and

managers deliberately keeping their strategies a secret.

2. The trend towards hedge fund self-institutionalization is the result of growth in the industry,

increased interest from institutions like pensions, and an attempt to reduce the likelihood of

further government regulation.

3. Position transparency means revealing the positions in a hedge fund, and it often includes a

great deal of information. Risk transparency is achieved by revealing a summary of exposures

to various risks and is more concise than position transparency.

4. The goal of equalization is to make sure the investors in the fund pay an appropriate portion of

the manager’s fee for the measurement period.

5. The main reason behind equalization is the possible distortions and inequitable fee payments

that can be caused by investors contributing capital during the measurement period.

6. In the absence of adjustments, each investor would pay a portion of the inventive fee simply

based upon the number of shares owned.

7. The free ride syndrome occurs when an investor buys shares in the middle of a measurement

period at a time when the shares have declined. The shares eventually recover and exceed

their beginning period value, and there are no fee adjustments. In such a case, the portion of

the incentive fee paid by the middle-of-period investors earned from the recovery of the share

prices.

8. Onshore funds are usually closed-ended and offshore funds tend to be open-ended. Being

open-ended introduces the need for adjustments in the payment of fees.

9. The multiple share approach is the practice of issuing a new class of shares for each new

inflow of capital to a hedge fund.

10. The main advantage of the multiple share approach is being able to keep track of how much

of the incentive fee each investor must pay. The main disadvantage is the fact that the number

of classes of shares can become quite large and difficult to track individually.

11. The equalization factor approach involves setting up a special account to be associated with

each inflow of cash that occurs in the middle of a measurement period. The account

represents a fee adjustment to the middle-of-period investor’s portion of the management fee.

12. Crystallization occurs at the end of the accounting period when there is a calculation of any

remaining equalization factors attributable to shareholders when the manager is paid the

incentive fee.

13. The equalization approach allows the NAV per share to be calculated as the gross asset value

minus the incentive fee earned at any given point.

14. The simple equalization approach records the different net asset values for each investor

based upon the time of the investment. At the end of the period, it assigns the lowest NAV of

all the shares to each share and makes up the differences in NAVs by issuing additional,

fractional shares to each investor who purchased shares at the higher NAVs during the period.

15. The simple equalization approach differs from the multiple-share approach in that the former

consolidates all its shares to one NAV at the end of each measurement period. The multiple-

share approach continues to record each series separately from period to period.

16. In a formula , the net return (holding period return) is:

������ � ����

������ �

����

������

�� � ������ � �

����

18. Gross returns are computed before deducting management fees and other expenses. Net

returns have had management fees and other expenses deducted.

19. The list of approaches to assign prices to determine net asset value includes the average

quote, the average quote with top and bottom removed, a median quote, and a subjective

judgment quote.

20. Valuation of illiquid assets usually includes a liquidity adjustment.

21. Cash accounting only records income when received and expenses when paid. Accrual

accounting matches income with expenses.

22. Trade date is the day the manager executes the order. Settlement date is when the cash

transfers to settle the executed order.

23. Let N equal the number of sub-periods in a year, then for i sub-periods:

���

���������� ������ � �� � ������ � ��

24. When calculating the performance of several funds, an equal weighting approach is equivalent

to a simple average of the returns of the funds.

25. The equal weighting approach is essentially a specific case of a weighted average that

assigns each fund return a weight of 1/N, where N is the number of funds.

26. An asset weighting approach for a portfolio of funds involves weighting each return by the ratio

of the assets in the respective fund to the sum of all the assets in the funds being analyzed.

27. Multiplying the individual fund returns by their respective weights and summing the resulting

weighted returns gives the aggregate return.

28. An arbitrary weight approach generally involves choosing weights in an arbitrary way that may

vary over time, with one caveat that the weights must sum to one.

29. The median fund return is the middle return of the sorted returns of a group of funds being

analyzed.

30. The continuously compounded return is rt�t�i� � ln(��Rt�t�i)��or simply the natural logarithm of

the gross return.

31. If a fund increases in value from $100 to $130, the continuously compounded return is

ln(�30/�00)�0.2624, or 26.24%.

32. To annualize a continuously compounded return, simply multiply the return by N/i, which is the

number of periods in a year divided by the number of sub-periods over which the return was

earned:

�

���������� ������ � � � ln �� � ������ �

�

33. Continuous compounding over several periods is simply the difference of the logarithms of the

ending NAV and the beginning NAV:

������

������ � �� � � � ��(������ ) � ��(���� )

����

3. Return and Risk Statistics

falling in mutually exclusive data intervals. Steps involved in creating relative frequency

histograms are:

• Set up mutually exclusive intervals.

• Assign each observation to one interval.

• Calculate the relative frequency (percentage of observations) within each interval.

• Plot the histogram charting the relative frequencies for each interval.

2. The arithmetic average return is the simple average return computed over a prespecified time

period. The formula for the arithmetic average return equals the sum of the periodic returns

divided by the number of periods over which the sum is computed.

3. The geometric mean return is the compound average return divided over a prespecified time

period.

4. The geometric return accounts for compounding. The arithmetic return does not account for

compounding. The geometric mean return will always lie below the arithmetic average return

and the difference between the two statistics widens as the data series becomes more

volatile.

5. In the case of continuously compounded returns, the geometric mean return simply equals

, where is the average continuously compounded return.

6. The median is the middle number within a ranked data series. The median provides a better

measure of the central tendency of a data distribution in the presence of outlier (or extreme)

values.

7. The average gain is the arithmetic average return computed over all periods in which the fund

manager earned a positive return. Similarly, the average loss is the arithmetic average return

computed over all periods in which the fund manager earned a negative return. The gain to

loss ratio equals the average gain return divided by the average loss return. A positive ratio

indicates that, on average, the fund manager’s average gains outpaced the average losses.

8. Performance rankings based solely on average fund returns are misleading because they

ignore the risks undertaken by each fund. Risk and return are inversely related. Therefore, low

risk funds will rank near the bottom based on long-term average rate of return.

9. Many definitions of risk exist. The common factors of all risk statistics are that they focus on

uncertainty and the chance of disappointing outcomes.

10. The range is the difference between the minimum and maximum values in a data distribution.

The range is not usually a good indicator of risk because it relies solely on two data points (the

extreme observations) and ignores all other intermediate observations.

11. A percentile is the percentage of observations in a data series that lies below a particular

th

value. For example, the 5 percentile return equals the return below which the portfolio

performed 5% of the time, and above which the portfolio performed 95% of the time.

12. The variance measures the extent to which a fund’s performance deviates from its mean

return.

13. Volatility is measured by the fund’s standard deviation, which equals the square root of the

variance of returns.

14. The formula for the variance for sampled data equals the sum of squared deviation of the

portfolio return from its sample mean divided by the number of sampled returns less one. The

formula for the variance derived from the entire population equals the sum of squared

deviations of the portfolio return from its population mean divided by the total number of

returns.

15. The variance formula using simple returns does not account for compounding effects. Instead,

the variance should be calculated using continuously compounded returns. The volatility that

accounts for compounding equals e raised to the power of the standard deviation of

continuously compounded returns less one.

16. The annualization procedure often employed for volatility ignores the effects of compounding.

Therefore, the calculation of the annualized volatility is inconsistent with the calculation of the

annualized return.

17. The researcher must balance the need for sufficient number of observations to derive reliable

volatility estimates with the reality that volatility is not constant over time.

18. Skewness refers to the extent to which the distribution of data is not symmetrical about its

mean. The tail of the distribution is elongated to the right for positively skewed data and is

elongated to the left for negatively skewed data. Positively skewed distributions have more

positive outliers than negative outliers. Negatively skewed distributions have more negative

outliers than positive outliers.

19. Kurtosis refers to the degree of peakedness in the data distribution. A distribution is said to be

leptokurtic if it has a peak that extends above that of a normal distribution, and has tails that

are fatter than those of a normal distribution. In contrast, a distribution is said to be platykurtic

if it has a peak that lies beneath that of a normal distribution, and has tails that are thinner

than those of a normal distribution.

20. The Beta-Jarque statistic is used to test data for departures from the normal distribution. The

formula for the statistic is:

",

!

where S is the skewness, and K is the kurtosis for the sampled data. If the data follow a

normal distribution, S equals 0 and K equals 0, and the Beta-Jarque statistic also equals zero.

21. The Beta-Jarque statistic follows a chi-square distribution with two degrees of freedom. The

null hypothesis that the data follow a normal distribution is rejected if the Beta-Jarque statistic

th

exceeds the critical value (usually the 95 percentile of the chi-square distribution with two

degrees of freedom).

22. Drawbacks of using volatility (standard deviation) as the measure of risk include:

• Asymmetric returns: the standard deviation is high for funds with many more

abnormally high returns versus abnormally low returns. Yet, few investors would

equate the abnormally good performance with risk.

• Benchmark: the standard deviation examines the volatility around the sample mean

return. Yet many investors equate risk with volatility around a target return such as a

minimum acceptable return or a benchmark return, rather than the sample mean

return.

• Risk aversion: the standard deviation weights positive and negative surprises equally.

Yet, most investors dislike negative surprises more than they like positive surprises.

23. Downside risk differs from volatility risk by focusing solely on returns that fall below a pre-

specified target return. Therefore, downside risk differs from traditional volatility risk in two

ways. First, downside risk focuses solely on negative surprise outcomes. In contrast, volatility

risk uses all returns, positive and negative surprises. Second, downside risk uses a

customized reference point or target return, #. In contrast, volatility risk uses the historical

mean return for the fund.

24. Semi-deviation equals the volatility of returns that fall below the historical mean return and is

used as a measure of downside risk.

25. Below-target semi-deviation equals the volatility of returns that fall below the returns a for pre-

specified benchmark, and is also used as a measure of downside risk. The below-target semi-

variance equals the square of the below-target semi-deviation.

26. Other measures that shed light on the riskiness of the fund are downside frequency, gain

standard deviation, and loss standard deviation. The downside

Frequency equals the number of negative surprise occurrences, indicating how often the fund

underperformed the target. The gain standard deviation equals the volatility of all positive

returns around the average positive rate of return, indicating upside volatility. The loss

standard deviation equals the volatility of all negative returns around the average negative rate

of return, indicating downside volatility.

27. Shortfall probability equals the chance that the fund’s return will be less than a pre-specified

target return.

28. Value at risk (VaR) is the maximum percent loss, equal to a pre-specified “worst case”

th

quantile return (typically the 5 percentile return). In contrast, expected shortfall is the mean

percent loss among the q-quantile worst returns.

29. Drawdown equals the percentage decline in asset value from its previous high.

30. Several drawdown statistics are used in practice. The maximum drawdown is the worst

percent loss experienced from peak to trough over a specified period of time. The

uninterrupted drawdown measures the duration of the consecutive loss periods as well as the

cumulative loss over the uninterrupted loss period. The drawdown duration is the amount of

time needed to totally recover the drawdown.

31. Drawdowns are more easily understood than volatility risk measures, but must be used

cautiously. In particular, maximum drawdowns are larger for assets that are valued more often

and increase with the time period examined, which place long time managers of daily marked-

to-market assets at a disadvantage.

32. Funds are often evaluated relative to pre-specified benchmarks, such as those defined below:

• Capture indicator: ratio fund average return to the benchmark average return.

• Up capture indicator: fund average up percent gains divided by benchmark average

up percent gains.

• Down capture indicator: fund average down percent gains divided by benchmark

average down percent gains.

• Up number ratio: number of periods in which a positive return for the fund and

benchmark coincided divided by the total number of positive returns for the

benchmark.

• Down number ratio: number of periods in which a negative return for the fund and

benchmark coincided divided by the total number of negative returns for the

benchmark.

• Up percentage ratio: number of periods in which the fund outperformed the

benchmark during up periods for the benchmark divided by the total number of

positive returns for the benchmark.

• Down percentage ratio: number of periods in which the fund outperformed the

benchmark during down periods for the benchmark divided by the total number of

negative returns for the benchmark.

• Percent gain ratio: number of positive returns for the fund divided by the number of

positive returns for the benchmark.

• Ratio of negative months over total months: number of negative monthly returns for

the fund divided by the total number of sampled months.

33. The beta of a hedge fund measures the sensitivity of its returns to changes in the benchmark

return. Beta does not measure the total risk of the fund: it measures only that part of the fund’s

risk that is related to the benchmark, often called market or systematic risk.

34. Tracking error measures the extent to which the portfolio’s returns deviate from the

benchmark returns over time. Therefore, tracking error quantifies the uncertainty (risk)

regarding deviations of the portfolio return from the benchmark return. A low tracking error

indicates that the fund performance closely resembles that of the benchmark. Several tracking

error statistics are used in practice, including the root mean difference from the benchmark,

the standard deviation of differences from the benchmark, and the mean absolute deviation

from the benchmark.

4. Risk-Adjusted Performance Measures

1. The Sharpe ratio measures the portfolio’s excess return per unit of (total) risk, determined by

the standard deviation of portfolio returns: .

2. The information ratio (IR) measures the performance of a portfolio relative to a prespecified

benchmark: . The numerator of the IR can also be viewed as the zero investment

hedge fund return on a long/short strategy that takes a long position in Portfolio P and an

offsetting short position in the benchmark.

3. Various tests of significance for differences in Sharpe ratios are often used. The Jobson and

Korkie test examines differences in Sharpe ratios between two portfolios, assuming normality

of portfolio returns. In contrast, the Gibbons, Ross, and Shanken test examines differences in

Sharpe ratios between a managed portfolio and the mean-variance efficient market portfolio.

Finally, the Lo test relaxes the distributional assumptions on the portfolio returns, incorporating

characteristics such as serial correlation and mean reversion.

4. The CAPM provides an equilibrium relationship between required returns for assets and their

betas: required return = . Therefore, according to the CAPM, the risk

premium for any asset equals . The graph of the CAPM is called the Security

Market Line, with intercept equal to the risk-free rate, , and slope equal to the market risk

premium, .

5. The Jensen alpha equals the difference between the return earned on the portfolio and the

portfolio’s CAPM required return.

6. The Treynor ratio equals portfolio excess return divided by beta.

7. The Treynor ratio differs from the Sharpe ratio by using the portfolio beta as the appropriate

measure of risk (in contrast to the Sharpe ratio that uses the standard deviation). The ratio of

the portfolio’s alpha to its beta equals the difference between the Treynor ratios for the

managed portfolio and the market index.

2

8. The M portfolio performance statistic compares the rate of return performance of a managed

portfolio versus the market portfolio, after controlling for differences in standard deviations.

2

The M measure applies leverage or deleverage to the managed portfolio (in order to match

the risk of the market portfolio).

9. Both GH1 and GH2 performance measures relax the assumption that the maturity of the risk-

free asset matches the portfolio evaluation period. Therefore, the maturity of the treasury

security may exceed the length of the evaluation period, exposing the treasury security to

interest rate risk. The end result is that the GH measures are derived using the curved

opportunity sets connecting the Treasury bill with the managed portfolio or with the market

portfolio. To control for differences in risk, the GH1 measure applies leverage/deleverage to

the market portfolio, whereas the GH2 applies leverage/deleverage to the managed portfolio.

10. The Sortino ratio measures rate of return performance for a portfolio, relative to its downside

risk. In contrast, the upside-potential ratio examines the expected upside return for a portfolio

(above the minimum acceptable return benchmark), relative to its downside risk.

11. Both the Sterling ratio and the Burke ratio evaluate rate of return performance relative to

drawdowns (percent losses) experienced by the portfolio. The drawdown measure differs

between the two ratios. The Sterling ratio uses the average extreme drawdown (or most

extreme drawdown), whereas the Burke ratio uses the square root of the sum of all drawdown

squared.

12. The return on value-at-risk, or RoVaR, equals the mean return earned on the portfolio divided

by the portfolio’s value-at-risk (in absolute value).

5. Databases, Indices, and Benchmarks

1. Self-selection bias results from the fact that managers voluntarily submit their performance

data to database vendors. Since funds with good track records and smaller funds with express

capacity and good results have an incentive to report (they cannot otherwise market or

advertise their results), an upward bias in the performance data results.

2. Sample selection bias results when database vendors impose inconsistent criteria across

vendors with respect to database inclusion (such as asset size and track record restrictions).

This results in incomplete samples with widely varying fund membership among different

database vendors.

3. Survivorship bias results when the history of dead, merged, or otherwise nonreporting funds is

excluded from the historical set of returns in the database, which results in an upward bias in

the database’s reported results.

4. Backfill bias occurs when a fund is allowed to include its historical returns upon its inclusion in

a database. The upward bias is estimated at 1.2% to 1.4% for databases that allow this

practice.

5. Illiquidity bias results when funds hold infrequently priced assets. Subjectivity in the valuation

process (i.e., the manager, rather than the market, assigns an asset its value) tends to smooth

returns and understate volatility (thus overstating risk-adjusted return measures).

6. The benefits of hedge fund indices are that they can provide a representation of the underlying

universe of hedge funds, provide correlation estimates as an input into an optimization

process, allow the investor to compare the risk and return trade-offs of various trading

strategies, provide the basis for a passive investment vehicle, and give the investor the ability

to compare individual hedge fund managers against an index of all managers.

7. The difficulties in constructing an effective index are that the indices will also contain the

databases’ biases, and classification may be inaccurate.

8. Characteristics of a well-constructed index include the following: the index fund is transparent

representative, capitalization weighted, investable, timely, and stable over time.

9. The key characteristics of the various hedge fund databases are as follows:

• ABN AMRO – Asian hedge funds, equal weighted, reporting restrictions (sample

selection issues).

• Altvest – CaLPERS uses this database which tracks 2,000 plus hedge funds and 14

indices. Funds may show up in several sub-indices.

• MAR/CISDM – has tracked data on managed futures since 1979 and on the hedge

fund industry since 1994. Now owned by the University of Massachusetts-Amherst.

Academic database of choice.

• CSFB/Tremont – indices start in 1994 and use 3,000 hedge funds from the TASS

database (fund of funds and managed accounts are excluded). Funds must have $10

million in assets under management and audited financial statements, and they must

meet requirements on disclosure and transparency. Indices are rebalanced monthly

with quarterly manager revisions. CSFB/Tremont created a series of investable

indices in 2003. They are the only capitalization-based index provider.

• Evaluation Associates Capital Markets – nontransparent, based on a small sample

size. EACM100 is the master index. They also have five broad strategy indices and 13

sub-strategy indices with data starting in 1990. Equally weighted, non-audited

performance data are provided by 100 participating hedge funds.

• Hedge Fund Research – pure indices with minimum bias problems. HFR has 37

equally weighted monthly performance indices (onshore and offshore). Returns are

net of fees and free of survivorship bias after 1994. No minimum asset size or track

record is necessary. They maintain dead fund history. In 2003, Hedge Fund Research

published one composite and eight investable indices (rebalanced quarterly).

• HedgeFund.net/Channel Capital Group (Tuna indices) – produces 32 equally

weighted indices from a database of 4,000 onshore and offshore hedge funds. Self-

selection, survivorship biases are present.

• Hennessee – produces 23 equally weighted indices and four composites based on a

sample of 500 hedge funds from a database of 3,000 funds. Restrictions of index

inclusion include: (1) a minimum of $100 million in assets under management or

greater than $10 million and a 1-year track record, and (2) satisfy reporting

requirements. Indices retain the historical performance of dead funds and include

several funds that are closed to new investors.

• Invest Hedge/Asia Hedge/Euro Hedge – HFI does not manage money or provide

investment advice. Data goes back to 2000 for HFI’s European hedge fund indices

and to 2001 for its Asian hedge fund indices.

• LJH Global Investments – small sample size, investable indices. LJH publishes 16

equally weighted indices of 25 to 50 hedge funds.

• Morgan Stanley Capital International – created a database of over 1,500 funds in

2002 and created premier hedge fund classification system based on the manager’s

investment process, the asset classes used, geographic location of investments, and

secondary classifications. Three composites based on asset size including broad

(greater than $15 million), core (greater than $100 million), and small ($15 million to

$100 million).

• Standard & Poor’s – equally weighted and primarily investable indices cover nine

styles and contain only 40 funds.

• ZCM – Zurich Capital Markets has failed at several attempts to create hedge fund

indices based on style while simultaneously offering investors fund of funds that would

track the indices’ performance.

• Van Hedge Fund Advisors International – comprehensive database of over 5,000

funds. Tracks 14 strategies and one global index based on a sample of 750 offshore

and onshore hedge funds.

10. The intuition of the EDHEC index is that each of the existing indices represents a sample of

the underlying universe with some noise created by database biases. By combining the

available indices and using PCA, the resulting index is a pure form index for the underlying

universe without bias problems.

11. Three key reasons why performance benchmarks are important are that they:

• Help measure the investment performance of hedge fund managers.

• Provide clients and trustees with a reference point for monitoring performance.

• Modify the behavior of portfolio managers who drift away from their investment

mandate.

12. The three reasons why the S&P 500 would be a poor hedge fund benchmark include the

following:

• Inconsistent holding periods and market exposures of managers versus the S&P 500.

• Hedge funds typically employ leverage and short sales.

• Hedge funds typically invest in shares of firms and asset classes not included in the

S&P 500.

13. The benefits of the relative peer group benchmarks are that they look at the performance of

other practitioners, reflect the differences or similarities between managers, and take into

account the transaction and trading costs. The drawbacks are that they suffer from selection

and survivorship bias, lack overall representativeness, and are not a viable passive

investment strategy. Peer groups are not useful to assess the performance of a manager in

general.

14. The essential elements of a manager benchmark are that it be unambiguous, investable,

appropriate, reflective, measurable, and specified in advance.

15. The following are the four properties that an ideal benchmark should possess: (1) simple to

understand, (2) replicable, (3) comparable, and (4) representative of the underlying market.

6. Covariance and Correlation

1. A scatter plot is a graph of paired observations fort wo variables, illustrating the relationship

between the variables.

2. The covariance is a statistic used to measure the relationship between two variables. The

covariance ranges from negative infinity to positive infinity. A positive covariance indicates a

positive relationship, a negative covariance indicates a negative relationship, and a zero

covariance indicates no relationship.

3. The formula for the sample covariance is:

4. The variance-covariance matrix is a square table arranged in a fixed number of rows and

columns that report variances and covariances. Variances are reported down the diagonal and

covariances are reported in the off diagonal cells. The covariance between variables i and j is

reported in Row i and Column j.

5. The covariance is unbounded, ranging from negative to positive infinity, with the actual

magnitude of the covariance providing little insight into the strength of the relationship. To

correct this problem, it is common to scale the covariance by the product of the standard

deviations of the two variables. By scaling the covariance, we derive the correlation.

6. The correlation between two variables (also known as the Pearson product-moment

correlation coefficient) equals:

7. A correlation matrix is a square table arranged in a fixed number of rows and columns,

conveniently providing correlations for different pairs of variables.

• The correlation between variables or ranks i and j, is reported in Row i and Column j.

• All correlations down the diagonal will equal 1.

8. The Spearman rank correlation equals the Pearson correlation of the variable rankings. The

Spearman rank correlation is particularly appropriate for data series that are not normally

distributed.

9. To calculate the Spearman rank correlation, convert each observation to a rank with the

lowest observation equaling one and then use the following formula:

10. Geometry can be used to illustrate the effects of correlation on portfolio risk. Portfolio risk can

be measured by the length of a vector. A leverage overlay is perfectly positively correlated

with the original portfolio, causing the new and old portfolio to lie at a zero degree angle to

each other. In contrast, a hedge overlay is perfectly negatively correlated with the original

portfolio, causing the new and old portfolio to lie at a 180 degree angle to each other. And, the

risk of the portfolio comprising uncorrelated assets equals the length of the hypotenuse of a

right triangle.

11. The correlation estimate measures the strength of the linear relationship between two

variables, but it does not necessarily imply a causal relationship between the two variables.

12. Correlation measures the direction and strength of the linear relationship between two

variables. It does not measure the strength of non-linear relationships.

13. A spurious relationship refers to an incorrect inference drawn from an observed correlation,

and is most often made when correlations are high between variables that have no logical

connection.

14. An outlier is defined as an extreme or abnormal observation that is not representative of the

majority of observations in the sample. Outliers cause the correlation to move toward zero,

which incorrectly implies a lack of relationship between the variables. The researcher should

attempt to use robust estimation methods that identify and diminish the weight or importance

of outliers in the correlation calculation.

15. The partial correlation is the correlation between two variables after controlling or removing

the effects of other related variables.

16. Sampling error refers to the difference between a sample statistic and the corresponding

population parameter that it is trying to estimate. Sampling error declines as the sample size

grows.

17. A confidence interval is an estimated range within which the population parameter is likely to

be contained. Confidence limits refer to the lower and upper bounds of the confidence level.

18. Statistical significance refers to the probability that a relationship observed in a sample did not

happen by chance. If the estimate is statistically significant, then the estimate is reliable.

19. The correlation confidence interval is the range within which the population correlation is likely

to be found.

20. A correlation estimate is statistically significant if its estimated confidence interval does not

include zero.

21. Heteroscedasticity refers to a data series characterized by a nonconstant dispersion (or

variance), which may cause the correlation estimate to be biased downward.

7. Regression Analysis

1. The general equation underlying any regression equals the sum of predictable and

unpredictable components.

2. The true regression model is unknown. Instead, we must rely on regressions derived from

estimated models.

3. Primary problems encountered by regression include:

• The selection of appropriate independent variables

• The use of appropriate estimation methods

• The evaluation of the quality of the estimated model

4. Linear regression is a statistical technique used to explain the linear relationship of the

dependent variable with one or more predictor or independent variables. The regression

equation is the mathematical representation of the linear relationship.

5. The use of sampled data introduces many errors into the regression estimation process. The

most common sampling errors include:

• Recording errors: errors recording the data in the database

• Non-synchronous pricing: last trades of the day not transacting at exactly the same

time

• Liquidity premiums: not all assets can be bought and sold with the same ease

• Discreteness: increments used to price assets may not represent true values

6. Linear regression should be viewed as a first order approximation of reality because, in reality,

most relationships are not perfectly linear.

7. The regression error term equals the difference between the observed and estimated values

of the dependent variable. Large errors indicate an inferior or useless regression; small errors

indicate a superior or useful regression.

8. Ordinary least squares (OLS) is a statistical technique that derives a regression line that

minimizes the sum of squared regression errors.

9. Desirable properties of OLS include:

• The regression errors remain as small as possible

• The regression will pass through the sample means of the dependent and

independent variable

• The errors are uncorrelated with the independent variable and with the estimated

dependent variable

• The estimates of the intercept and slopes are the best linear unbiased estimates

10. The slope coefficient equals the average change in the dependent variable for every 1-unit

change in the independent variable. The formula for the slope coefficient estimate is ,

where sx,y is the sample covariance between the dependent and independent variables (Y and

X, respectively), and is the sample variance for the independent variable.

11. The intercept is the point of intersection of the regression line with the Y-axis. The formula for

the intercept estimate is .

12. The multiple R is the correlation between the realized values and the predicted values of the

dependent variable.

13. The R-square is the fraction of the dependent variable’s variance that is explained by the

regression. The R-square equals the square of the multiple R, and is also equal to the

regression sum of squares divided by the total sum of squares.

14. The standard error of the estimate is the standard deviation of the regression residuals. A

large standard error indicates that the scatter around the regression line is large, suggesting

the regression is inferior.

15. ANOVA, or analysis of variance, refers to the decomposition of the variance of the dependent

variable into explained and unexplained components.

16. The F-statistic is the test statistic used to test the overall significance of the regression:

H0: all slopes equals zero

HA: not all slopes equal zero

The formula for the F-statistic equals the ratio of the mean explained variation to the mean

unexplained variation.

17. A p-value equals the probability that the null hypothesis is correct. The null hypothesis, H0:

slopes = zero, is rejected if the p-value is less than the significance level used for the test

(typically 5%).

18. The t-statistic for the slope estimate equals the slope estimate divided by its standard error.

The null hypothesis, H0: slope = 0, is rejected if the t-statistic exceeds its critical value (which

equals 1.96 for a large sample based on a 5% level of significance).

19. A confidence interval is the reasonable range within which the true unknown parameter (e.g.

slope) is likely to be found. The null hypothesis, H0 = 0, is rejected if the confidence interval

does not contain the hypothesized value (0).

20. Several difficulties limit the usefulness of regression to derive accurate forecasts for the

dependent variable. These difficulties include unpredictability of the independent variables,

instability of regression parameters, out-of-sample predictions, and spurious relationships.

21. Regression is often used to predict the dependent variable. Using a simple linear regression,

the predicted value for Y equals , in which and are the estimated intercept and

slope (from past data), and X is the predicted value for the independent variable.

22. Multiple linear regression refers to a linear regression of a dependent variable against multiple

independent variables.

23. In contrast to the R-square, the R-adjusted considers the number of independent variables

used in the regression. The formula for the R-adjusted equals:

24. To test the overall significance of a multiple regression, the F-statistic is used:

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25. Omitted variable bias is present when independent variables that should be in the model are

omitted. The consequences of this bias depend on the correlation between the included and

omitted variables. If the correlation equals zero, then the intercept estimate is biased and the

regression residuals might deviate from the normal distribution. If the correlation equals 1,

then all the parameters are adversely affected (intercept and slope estimates are biased, and

regression residuals might be non-normal).

26. Extraneous regression variables refer to regressions that include irrelevant independent

variables. If the extraneous variable is uncorrelated with the relevant independent variables,

then there is no bias. On the other hand, if the extraneous X variable is correlated with the

relevant X variables, then the standard errors of the parameter estimates will be inflated,

causing the t-statistics to fall.

27. Multicollinearity refers to the violation of a regression assumption that all the independent

variables are uncorrelated with each other. Multicollinearity causes the intercept and slope

standard errors to be biased upward, and t-statistics to be biased downward.

28. Heteroscedasticity refers to the violation of a regression assumption that the variance of the

regression errors is constant across all observations. There are two common corrections for

heteroscedasticity:

• Use a different specification for the model (different X variables, or perhaps non-linear

transformations of the X variables)

• Apply a weighted least squares estimation method, in which OLS is applied to

transformed or weighted values of X and Y. The weights vary over observations,

depending on the changing estimated error variances.

29. Serial correlation refers to the violation of the regression assumption that the regression errors

are uncorrelated across observations.

30. The Durbin-Watson test refers to the test of the hypothesis that the regression errors are not

serially correlated. For a large sample, the Durbin-Watson test statistic equals approximately

2(1-corr), where corr is the correlation between successive regression residuals. The null

hypothesis of no serial correlation will usually be accepted if the Durbon-Watson statistic lies

between 1.5 and 2.5.

31. Non-linear regression refers to regressions in which the relationship between the dependent

and one or more of the independent variables in non-linear. A model in which the effects of the

independent variable on the dependent variable change over time will produce a curved

relationship between the dependent and independent variable. A typical example is the

regression:

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32. Transformations refer to non-linear modifications (e.g., ratios, trigonometric functions, and

logarithms) to the original data.

33. Stepwise regression refers to a method in which independent variables are selected

sequentially based on incremental explanatory power.

34. The backward elimination stepwise regression approach begins by including all independent

variables chosen to be analyzed by the researcher. Each independent variable is then

evaluated based on its ability to explain the dependent variable. The variable that explains the

least (smallest slope coefficient t-statistic) is eliminated, and the process is repeated until all

variables significantly contribute to the explanatory power of the regression.

35. The forward selection stepwise regression approach begins with no independent variable. The

first variable added to the model is the one with the highest slope t-statistic. Then, other

variables are added sequentially, depending on the magnitude of their t-statistics.

36. Hierarchical multiple regression uses similar statistical tests as those applied in stepwise

regression, except that the researcher, not the computer, selects the order in which the

independent variables are sequentially tested and added to the model.

37. In contrast to simple linear regression, non-parametric regression makes very few

assumptions about the behavior of the data (normality of the error term, homoscedasticity of

the errors, no serial correlation among the errors, etc.) or about the exact functional form of

the relationship between Y and X. Non-parametric regression is a data smoothing method.

8. Asset Pricing Models

1. Dimension reduction is taking a large amount of data and condensing it into a much smaller

number of variables or factors, without losing the information content of the data set.

2. Factor models provide insight into a fund’s risk/return profile (including the risks taken by the

fund’s managers), allow for accurate risk attribution, help with accurately forecasting future

risks, and identify the contribution the manager is making to the fund’s overall return.

3. A factor model should be intuitive, should be estimated in a reasonable amount of time, should

be parsimonious, should reflect commonalities across funds, and should help managers with

decision making.

4. A general linear factor model expresses returns as a function of a single factor.

5. The Capital Asset Pricing Model (CAPM), the most famous single-factor model, expresses

return as a function of the market risk of the asset.

6. Single-factor models are too limited to capture the complexity of hedge fund returns. Consider

the various hedge fund styles, investment opportunities, markets, long and short positions and

degrees of leverage as examples of this complexity.

7. In a general linear multi-factor model, return is related to more than one underlying risk factor.

In general form the model is:

8. Principal component analysis is a statistical technique that allows the researcher to distill a

vast amount of data into a few common factors without losing much of the information in the

original data (thus accomplishing dimension reduction). The factors are implied by the data

and do not have a direct economic interpretation.

9. Common factor analysis is another statistical tool used to accomplish dimension reduction. A

key difference is that the factors in factor analysis are observable and explicitly identified by

the researcher.

10. Fama and French developed a three-factor model that includes two additional risk factors

relative to the CAPM. Their model indicates that both market capitalization (SMB) and book-

to-market ratios (HML) help explain returns.

11. Jagadeesh and Titman find evidence of a momentum effect in stock market returns. That is,

stocks that have performed well continue to perform well and stocks that have performed

poorly continue to perform poorly (WML).

12. The Fama and French model redefined to include a momentum factor is:

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13. Other factors that may influence hedge fund returns, as suggested by various researchers,

include trading styles, interest rates, equity related factors, growth, the age and/or size of the

fund, and so on.

14. An analyst or investor can use multiple-factor models to help explain hedge fund returns and

risks, help create performance benchmarks and index trackers, help develop trading

strategies to increase sensitivity to some risk factors and decrease it to others, and to help

assess whether a manager generated positive alpha.

15. Traditional asset models assume that volatility is the appropriate risk measure for an asset (or

portfolio of assets) and that risk exposures are constant over time.

16. Skewness is a measure of the asymmetry of the distribution. It is the third moment of the

return distribution. Investors prefer positive skew and want to avoid negative skew. Co-

skewness considers an asset’s contribution to the skewness of the portfolio or fund, and is

more relevant than the skewness of the asset alone.

17. Kurtosis is the fourth moment of the distribution and measures the “peakedness” of the

distribution. Co-kurtosis is concerned with the kurtosis contribution of an asset to the portfolio

or fund.

18. Rubinstein developed a model relating return to the higher moments of the distribution such as

skewness and kurtosis.

19. Kraus and Litzenberger developed a three-moment CAPM (i.e. a quadratic CAPM) that allows

an analyst to test for skewness preferences. The model is:

20. The cubic form of the model includes a factor that is related to the fourth moment (kurtosis).

The model is:

21. In 1966 Treynor and Mazuy proposed a quadratic asset pricing model that considers market

timing as a systematic risk factor. The model is identical to the quadratic model proposed by

Kraus and Litzenberger.

22. Conditional asset pricing models such as the CAPM assume risk is constant through time.

Unconditional models do not make this assumption and thus may be more appropriate for

modeling hedge fund returns.

23. Hedge funds are like options in terms of their fee structure, in terms of trading strategies that

target classes of investors and in terms of the asymmetric, non-linear payoff profiles.

24. Henriksson and Merton (1981) developed a model that views a hedge fund’s return as the

sum of the return on the market and on a put option on the market. The model is:

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25. Fung and Hsieh identify three components to hedge fund returns: location factors, trading

strategy factors, and a leverage factor.

26. Fung and Hsieh provide a framework for looking at hedge fund strategies in terms of option

strategies.

27. Agarwal and Naik propose several buy-and-hold risk factors that influence hedge fund returns.

They include equity, bond, style and default spreads.

2

28. Agarwal and Naik find that their model has better explanatory power (higher R ) than the Fung

and Hsieh model.

29. Amin and Kat show that investors can generate the same payoff distribution as a hedge fund

using dynamic trading strategies.

30. An investor can achieve superior returns by either increasing beta (taking on more risk) or

generating alpha (being a superior market timer, asset selector, etc.).

31. If the asset pricing model is specified incorrectly, it is possible to make the erroneous

conclusion that hedge fund managers are generating positive alpha when in reality they are

merely increasing beta exposure.

9. Styles, Clusters, and Classifications

1. Hedge funds can use self-classification, but because of the lack of stringent regulation, it is not

unusual for a hedge fund manager to deviate from the goal of the fund as implied by its name

and even the goal as stated in the prospectus. Hence, quantitative methods are needed to

classify hedge funds.

2. Fundamental style analysis, also called holding-based style analysis, classifies hedge funds

by the type of assets held. Characteristics like the assets’ markets and geographical location

classify the fund.

3. The characteristic-based approach is similar to the fundamental approach except it uses

measures like the assets’ book-to-market, momentum, etc.

4. Return-based style analysis only requires the historical returns of the funds. Hence, it is an

easier and cheaper substitute for holdings-based (fundamental style) analysis. However, it can

be much less accurate.

5. Multifactor analysis involves the estimation of the following model:

,

where the factors are usually style indices and the betas are the style sensitivities.

6. In estimating the multifactor model, the style indices should have the following three

properties: mutually exclusive, exhaustive, and sufficiently different in their behavior from each

other.

7. Analysts usually constrain multifactor analysis with either or both of the following: (1) the sum

of the betas equals 100%, (2) some or all of the betas are greater than or equal to zero.

8. Strong style analysis is the name used when both constraints are imposed: the betas cannot

be negative, and the betas sum to 100%.

9. The familiar R-square, or percent of variation explained, measure applies to constrained

optimization estimation techniques used in multifactor analysis. It tells how well the model fits

the data.

10. Style analysis radar charts can give a succinct, visual representation of the style exposures of

a fund. Such a chart has rays extending from a point of origin, and each ray indicates a

different style index. A set of lines crossing the rays indicate the level of exposure to each

style.

11. The Herfindahl-Hirschman concentration index, or HHI, gives a quantitative measure of the

diversification of the fund. It is the sum of the squared betas from a multifactor analysis divided

by the square of the sum of the betas:

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12. Rolling window analysis can indicate how a fund’s investment style changed over time. It

performs the multifactor analysis on an initial sub-period and then performs it over and over on

a new sub-period moved one period forward from the previous period. The pattern of the

many sets of betas reveals whether the strategies of the fund might have drifted over time.

13. Rolling benchmarks allow an analyst to track the manager’s style drifts, while static analysis

does not.

14. The Lobesco and DiBartolomeo style weight error is essentially the standard error of a style

exposure: % . It is represented by ()* , and it can be used to compose standard confidence

intervals like # % + ()* , % + ()* ' for a 95% confidence interval.

15. Style analysis can be misused due to the use of subjective inputs and because an analyst

may find it easy to rely too much on the quantitative results and neglect important qualitative

analyses.

16. Making adjustments to measure current exposure is important because a factor analysis of

past data may not accurately reflect current exposure.

17. The Kalman filter uses multifactor analysis to model the changes of sensitivities over time and

can give an indication of current exposure and even predict future exposure.

18. The Swinkels and van der Sluis’ application of the Kalman filter models the changes of

sensitivities (e.g., the betas) as a random walk.

19. The Kalman smoother is a descriptive technique that uses the entire data set to describe the

style sensitivities at any point. It is superior to rolling windows, which only use past data to

show changes in style sensitivities at any point in time.

20. In hedge fund analysis, cluster analysis attempts to group funds by certain characteristics.

21. The four common steps of cluster analysis are choosing (1) the characteristics, (2) the

measure of distance, (3) the particular algorithm, and (4) the interpretation of the results.

22. In cluster analysis, an analyst may wish to standardize the data in some way (e.g., removing

the effect of leverage from the funds under study).

23. Cluster analysis uses distance functions to determine the degree of similarity of objects.

24. Distance functions must have the following four properties:

• Identity: D(m,m) = 0

• Non-negativity: D(m,n) = 0

• Symmetry: D(m,n) = D(n,m)

• Triangle inequality: D(m,n) < D(m,q) + D(q,n)

25. The Minkowski class of distances refers to all functions that take the following shape:

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26. There are two often-used values for s in the Minkowski class: s = 1 and s = 2. An analyst

would rarely assign s > 2, because this would give outliers too high of a weight.

27. When s = 1 in the Minkowski class, it is simply the sum of absolute deviations called the

Manhattan distance or city-block distance.

28. When S = 2 in the Minkowski class, the result is the standard Euclidean distance.

29. A higher correlation between two funds means they are more similar and should have a

smaller distance. One transformation to create a distance function using correlation is:

72,

- .,

30. Binary distance is a simplistic measure in which an exact match gives a value of one, and the

value zero indicates no match exists between any pair of cases.

31. Euclidean distance can be biased if the characteristics have widely different variances.

32. The Mahalanobis distance corrects for the biases in Euclidean distance associated with

correlated characteristics and different variances.

33. The hierarchical clustering approach is a step-wise procedure that can be either top down or

bottom up.

34. Johnson’s hierarchical clustering algorithm begins by having each fund in its own group. It

then looks for the distance between two clusters that is the shortest of all distances between

any two clusters. The two clusters that are the closest become one cluster. The process then

repeats with the new set of clusters.

35. Johnson’s hierarchical clustering algorithm can use one of many distance measures. Once the

clustering has started, the distance may be either the distance between the closes two

members of each pair of clusters, for example, or the most distant two members.

36. Ward’s method uses an analysis of variance approach to evaluate each step in the clustering

process. It forms the next cluster at each step that minimizes the increase in the total of the

sums of squares within groups.

37. Fuzzy clustering gives each object a set of probability values – one probability for each

cluster. Each of the probability values essentially tells the likelihood of that object belonging to

a given cluster.

38. Hard clustering is the term used for traditional approaches that set up partitions and give only

one cluster assignment to each object.

39. The Rand index is a measure of the difference of the clustering results that different

algorithms produce.

40. When comparing two methods, the Rand index is essentially the percent of pairs that are in

the same cluster in both clustering algorithms. Rand index = 1 means identical groupings.

Rand index > 0.7 means the groupings are stable across methods.

41. Martin, Brown and Goetzmann, and Bares et al. are three studies of clustering analysis as

applied to hedge funds:

• Martin found that some classifications were more stable over time than others, and

that individual funds in a given cluster can react quite differently to changes in

economic conditions.

• Brown and Goetzmann found a great deal of heterogeneity in hedge fund behavior.

Style classifications explained 20% of the differences, and the style of fund

management determined the persistence of fund returns from year to year.

• Bares et al. performed cluster analysis based on managers. The managers’ records

had been gathered from the FRM database where they had already been classified.

Bares et al. found that the clustering analysis gave results similar to the classifications

the funds had in the FRM database. Other analysis supported the usefulness of

cluster analysis in classifying hedge funds.

10. Benefits and Risks Revisited

1. Three reasons for superior returns of the hedge fund industry are:

• Fewer investment restrictions

• Less constrained work environment

• Superior compensation

2. Hedge fund index returns have been higher than most major stock and bond market indices.

Standard deviations and maximum drawdowns have also been less than those of major equity

indices.

3. Correlations among traditional global market indices increased recently. Correlations between

stock and bond markets, at times, also have been high. Therefore, hedge funds have become

an increasingly attractive diversification alternative.

4. Rates of return and standard deviations are much better for hedge fund indices versus the

S&P 500 during bear markets. Therefore, hedge funds (as a group) have delivered on their

intended objective to provide important downside risk protection.

5. Risk, return, and correlations have varied widely across the different hedge fund strategies. As

expected, market neutral and arbitrage strategies exhibited the lowest risk and strategies with

directional bias exhibited the highest risk. Short bias strategies exhibited a large negative

correlation with the S&P 500, while net long, distressed risk, and emerging market strategies

exhibited the largest positive correlations with the S&P 500.

6. Hedge fund strategies are generally positioned into four different styles or categories:

• Low risk – low return: relative value strategies, such as market-neutral and arbitrage

strategies

• Low risk – high return: distressed risk strategies

• High risk – low return: risk diversifying strategies, such as managed futures and

emerging market strategies

• High risk – high returns: global macro and long/short strategies

7. A long-term analysis of hedge fund performance is difficult because very few funds have

existed for an extended time period. Since current analysis has been confined to a period in

which the broad market has risen, strategies with a long bias have enjoyed a performance

advantage.

8. Hedge fund index performances are difficult to track because they are computed gross of

transaction costs and do not consider the minimum investment. Moreover, hedge funds are

under no mandatory reporting requirement, so underperforming managers may elect to not

report their performance. This introduces an upward bias. Therefore, hedge fund index

performance may not be representative of the entire hedge fund industry.

9. Some hedge fund strategies rely on the exploitation of a limited set of opportunities.

Therefore, constrained opportunity strategies have encountered a particularly difficult time as

more capital has poured into these funds, and as a result have not sustained their earlier

successes.

11. Strategic Asset Allocation

1. Strategic asset allocation is the process of choosing portfolio weights for asset classes as

opposed to choosing the individual assets within each class. The choice of weights should

be for a long-term horizon and should be congruous with the investor’s return objective

and risk tolerance.

2. The St. Petersburg paradox is a game with an infinite expected value payoff. However,

people will only pay a finite amount to play because of risk aversion. It serves as an

example to prove people are risk averse.

3. Utility functions can describe an investor’s preference for return and aversion to risk. The

quadratic utility function is a popular function that includes an easily interpreted

expression for risk aversion:

4. The steps in portfolio optimization: select the appropriate asset classes, make forecasts,

recognize constraints such as non-negativity of certain asset class weights, optimize

based on a criteria such as minimizing risk for each given level of return, review the

results, and perform sensitivity analysis.

5. There are problems with saying that hedge funds are an “asset class”. There are many

different types of hedge funds. They often include risk exposures found in traditional

assets, such as stocks and bonds.

6. When including hedge funds in a portfolio, a manager should recognize how they might

serve as substitutes for traditional asset classes. This is because they often have risk

exposures and return characteristics similar to traditional assets (e.g., a long/short equity

fund that is net long will have returns that are correlated with the returns of an equity

index).

7. Since traditional methods of analysis do not seem to apply to hedge funds, managers

often choose informal approaches such as arbitrarily picking a small allocation (e.g., 5%,

for hedge funds). Another informal approach is to simply allocate zero capital to hedge

funds without performing any analysis.

8. Mean-variance optimizer solutions have problems when applied to hedge funds because

they do not consider skewness and kurtosis, which hedge fund returns generally exhibit.

9. The Taylor series expansion illustrates the role higher moments about the mean (such as

skewness and kurtosis) play in an investor’s utility function. The formula is:

10. Mean-variance optimization works fairly well when a portfolio only includes traditional

asset classes because the returns for these classes are usually close to being normal,

which means that moments higher than the second moment are (close to) zero. In

contrast, the higher moments for hedge funds can be quite large, and mean-variance

optimization may not give the most efficient asset class weights when hedge funds are

included in the portfolio.

11. The differences between static buy-and-hold portfolios and dynamic portfolios is another

reason that mean-variance optimization may not be appropriate for choosing hedge fund

weights. This is because hedge funds are usually actively managed and their

characteristics can change quite dramatically over the investment horizon. Thus, the initial

strategic asset allocation may become inappropriate soon after its implementation.

12. Because of the way hedge fund returns are reported (i.e., based on estimates rather than

actual transactions), the time series of the returns may be artificially smooth. This can lead

to downward bias in the calculated values of return variance.

13. Geltner proposed the following transformation, which uses the autocorrelation coefficient

of the observed returns to unsmooth the data:

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14. Methods for eliminating estimation risk include (1) subjectively adjusting forecast as new

information arrives, (2) the statistical shrinkage approach, (3) combining market

equilibrium values with investor’ expected returns, and (4) bootstrapping. There is also the

Michaud resampled efficiency algorithm to limit the impact of estimation risk.

15. Non-standard efficient frontiers use risk measures other than variance (e.g., the semi-

variance, VaR, and shortfall risk). Evidence of the benefits of this approach is not strong.

There are potential problems with the approach including estimation risk and difficulties in

relating the risk measures of individual positions to the overall portfolio.

16. Portable alpha refers to an investment strategy designed to transfer the excess return

(alpha) of one portfolio to another portfolio.

17. The following is an expression for total return:

$ ,- ! ,-./, 0,&/ ! %! 0/1, 2 ! 0,&/ !

This helps indicate how to separate alpha from a position that is not market neutral. The

manager can neutralize the second expression with, for example, a position in derivatives.

The new portfolio has only pure alpha and can serve as a means for adding alpha to

another portfolio.

18. The portable alpha mindset is one where an investor can benefit from the skills of

managers of funds that have risk exposures the investor may not want. The investor can

eliminate the risk and transport the alpha to his or her portfolio.

19. Hedge funds usually have both alternative risk exposures and exposures to the risks of

traditional assets. Pinpointing the specific types and levels of risk of hedge funds and

other assets under consideration will lead to the construction of more optimal portfolios.

20. Risk budgeting is the selection of asset classes on the basis of their expected

contributions to overall return and risk with the goal of achieving a level of return with only

the desired risk exposures and aggregate level of risk.

12. Risk Measurement and Management

1. The crucial risk management activities are to understand the risk exposures, measure the

exposure to each risk, measure the aggregate exposure of each fund, measure the risk of the

hedge fund portfolio, and choose the risk exposures.

2. Value at risk (VaR) is generally interpreted as the worst possible loss under normal conditions

over a specified period.

3. The main assumptions of parametric VaR are that the risk factors are normally distributed and

that the fund’s prices and returns have a linear relationship with the risk factors.

4. Historical VaR assumes that the historical patterns indicate the distribution of current and

future outcomes such that losses in the future will occur with the same frequency and

magnitude as they did in the past.

5. Monte Carlo VaR simulates values for risk factors and uses them to simulate returns for a

hedge fund or portfolio of funds.

6. Parametric VaR can greatly underestimate VaR if the normality of returns and other

parametric VaR assumptions are not true. Modified VaR attempts to incorporate adjustments

when the distribution is near but not exactly normal.

7. Modified VaR incorporates skewness and kurtosis into parametric VaR.

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8. Modified VaR is not reliable if the measures of skewness and kurtosis are too large.

9. Extreme events are those that occur in the tail of the assumed distribution. Two approaches to

model them are (1) gather a sample, divide the sample into blocks, measure the minimum

return in each of these blocks; (2) model the behavior of observations in the tail of a

distribution separately from those near the center.

10. A multi-factor style analysis allows for the calculation of value at market risk (VaMR), which is

the maximum loss from adverse changes in market factors that can occur under normal

conditions. Estimating value at market risk uses the betas from a multi-factor style analysis

and assumed values for the factors that have been pushed to a disadvantageous level.

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11. Value at specific risk is essentially the square root of the unexplained variance of the return

from a multi-factor analysis times the corresponding z-value for the level of confidence.

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12. The expression for total VaR obtained using style analysis is:

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13. The liquidity spread is the loss incurred from withdrawing funds today as opposed to waiting N

periods, and it is the difference in the corresponding net asset values.

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14. Laporte’s model or L-VaR breaks down VaR into the following parts: systematic market VaR,

specific market VaR, systematic liquidity VaR, specific liquidity VaR, and correlation effects

between liquidity and market risk. This decomposition allows for a more detailed analysis of

the effect of liquidity constraints.

15. The main limitation of VaR is that it gives a value of potential loss only under normal

conditions, and it does not indicate the losses that can occur when extreme events occur.

Other limitations are that it is a single measure that should not preclude the use of qualitative

analysis.

16. Stress tests compute the losses to a fund when extreme market moves occur. The test may

use extreme historical values, estimates of extreme values using statistics, or worse case

losses from a Monte Carlo simulation.

17. Monte Carlo simulations can provide thousands of hypothetical returns for both a single fund

and a portfolio of funds. One general approach is to fit a statistical distribution to the historical

returns of a fund and generate values using that distribution. When applied to generating

portfolio returns, the simulations will need to include the correlations of the funds’ returns.

18. Marginal VaR (MVaR) is a measure of how a portfolio VaR changes from a small change in

the position of a fund in the portfolio.

19. Incremental VaR (IVaR) is an estimate of the amount of risk a proposed position will add to

the total VaR of an existing portfolio. It is the proposed weight for that fund times the marginal

VaR evaluated when wi is zero.

20. Component VaR (CVaR) is the contribution of a particular fund to a portfolio of funds. It will

generally be less than the VaR of the fund by itself because of the diversification of some of

the fund’s risk at the portfolio level.

21. Managing a portfolio of funds might begin with decomposing the risk into the CVaR of each

position. This can indicate if any one position is a hot spot. In determining the correct course

of action, the manager can use marginal VaR to estimate the effect of changes in existing

positions, or the manager can use incremental VaR to estimate the effect of adding a new

fund to the portfolio.

22. A manager should remember that VaR values are estimates. Furthermore, each fund will have

special features that will affect its liquidity.

23. Studies have shown significant benefits even from naïve diversification, which is taking equal

positions in different funds. Smart diversification, which uses the characteristics of the funds to

adjust the weights, can further increase the benefits. Most of the benefits can be achieved with

five to ten funds.

24. Di-worse-ification is the result of having too many positions. Adding a position without

reducing other positions will generally increase the portfolio’s VaR in nominal terms. Also,

there is a decrease in the marginal benefits of diversification as the manager adds new

positions. Transaction costs can exceed potential benefits if there are too many positions.

Standards of Professional Conduct

I. Professionalism

Members and candidates must understand and comply with all applicable laws, rules,

and regulations of any government, regulatory organization, licensing agency, or

professional association governing their professional activities. In the event of conflict,

members and candidates must comply with the more strict law, rule or regulation.

Members and candidates must not knowingly participate or assist in any violations of

laws, rules, or regulations and must disassociate themselves from any such violation.

Members and candidates must use reasonable care and judgment to achieve and

maintain independence and objectivity in their professional activities. Members and

candidates must not offer, solicit, or accept any gift, benefit, compensation, or

consideration that reasonably could be expected to compromise their own or another’s

independence and objectivity.

C. Misrepresentation

Members and candidates must not knowingly make any misrepresentations relating to

investment analysis, recommendations, actions, or other professional activities.

D. Misconduct

Members and candidates must not engage in any professional conduct involving

dishonesty, fraud, or deceit or commit any act that reflects adversely on their

professional reputation, integrity, or competence.

Members and candidates who possess material nonpublic information that could

affect the value of an investment must not act or cause others to act on the

information.

B. Market Manipulation

Members and candidates must not engage in practices that distort prices or artificially

inflate trading volume with the intent to mislead market participants.

III. Duties to clients

Members and candidates have a duty of loyalty to their clients and must act with

reasonable care and exercise prudent judgment. Members and candidates must act

for the benefit of their clients and place their clients’ interests before their employer’s

or their own interests. In relationship with clients, members and candidates must

determine applicable fiduciary duty and must comply with such duty to persons and

interests to whom it is owed.

B. Fair Dealing

Members and candidates must deal fairly and objectively with all clients when

providing investment analysis, making investment recommendations, taking

investment action, or engaging in other professional activities.

C. Suitability

1. When members and candidates are in an advisory relationship with a client, they

must:

experience, risk and return objectives, and financial constraints prior to

making any investment recommendation or taking investment action and must

reassess and update this information regularly.

b. Determine that an investment is suitable to the client’s financial situation and

consistent with the client’s written objectives, mandates, and constraints

before making an investment recommendation or taking investment action.

c. Judge the suitability of investments in the context of the client’s total portfolio.

specific mandate, strategy, or style, they must make only investment

recommendations or take investment actions that are consistent with the stated

objectives and constraints of the portfolio.

D. Performance Presentation

must make reasonable efforts to ensure it is fair, accurate, and complete.

E. Preservation of Confidentiality

Members and candidates must keep information about current, former, and

prospective clients confidential unless any of the following occur.

1. The information concerns illegal activities on the part of the client or prospective

client.

IV. Duties to Employers

A. Loyalty

In matters related to their employment, members and candidates must act for the

benefit of their employer and not deprive their employer of the advantage of their skills

and abilities, divulge confidential information, or otherwise cause harm to their

employer.

consideration that competes with, or might reasonably be expected to create a conflict

of interest with, their employer’s interest unless they obtain written consent from all

parties involved.

C. Responsibilities of Supervisors

Members and candidates must make reasonable efforts to detect and prevent

violations of applicable laws, rules, regulations, and the Standards by anyone subject

to their supervision or authority.

making investment recommendations, and taking investment actions.

investigation, for any investment analysis, recommendation, or action.

1. Disclose to clients and prospective clients the basic format and general principles

of the investment processes used to analyze investments, select securities, and

construct portfolios, and must promptly disclose any changes that might materially

affect those processes.

investment analyses, recommendations, or actions, and include those factors in

communications with clients and prospective clients.

and recommendations.

C. Record Retention

Members and candidates must develop and maintain appropriate records to support

their investment analysis, recommendations, actions, and other investment-related

communications with clients and prospective clients.

A. Disclosure of Conflicts

Members and candidates must make full and fair disclosure of all matters that could

reasonably be expected to impair their independence and objectivity or interfere with

respective duties to their clients, prospective clients, and employer. Members and

candidates must ensure that such disclosures are prominent, delivered in plain

language, and communicate the relevant information effectively.

B. Priority of Transactions

Investment transactions for clients and employers must have priority over investment

transactions in which a member or candidate is the beneficial owner.

C. Referral Fees

Members and candidates must disclose to their employer, clients, and prospective

clients, as appropriate, any compensation, consideration, or benefit received by, or

paid to, others for the recommendation of products or services.

16. Introduction to Real Estate Valuation

1. The future value of a lump sum is equal to the present value compounded by an interest rate

for one or more periods.

• Future value can be calculated for any number of periods and interest rates using the

following formula:

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• Future value can be calculated for any number of periods using the same interest rate

with the following formula:

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2. The present value of a lump sum is equal to the future value discounted by an interest rate for

one or more periods.

• Present value can be calculated for any number of periods and interest rates using

the following formula:

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• Present value can be calculated for any number of periods using the same interest

rate with the following formula:

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3. The discounted cash flow approach to valuing real estate property requires estimating all

future cash flows for the property, which are then discounted to their corresponding present

values and summed.

• If it is appropriate to use a different discount rate for each period, the value of a

property can be calculated using the following formula:

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• If it is appropriate to use the same discount rate for each period, the value of a

property can be calculated using the following formula:

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4. Generally it is not feasible to forecast all future cash flows. Thus, the use of a reversion value

at the end of the forecast period is necessary to represent cash flows beyond the forecast

period. The reversion value is added to the final forecast year’s cash flow and requires that net

operating income is stabilized and will grow at a constant rate. Reversion value can be

calculated as follows:

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5. Net present value (NPV) is the present value of an asset minus its initial cost and represents

the increase in firm value by investing in the asset. NPV can be used to make investment

decisions using the following rules:

• If NPV > 0, the investment is acceptable.

• If NPV < 0, the investment should be rejected.

• If NPV = 0, the investment is acceptable but will add no equity value.

6. Calculating the NPV of an investment involves discounting the expected cash flows, summing

the discounted cash flows, and subtracting the initial cost to undertake the investment.

7. An investment’s internal rate of return (IRR) is the discount rate that results in an NPV equal to

zero. IRR can be used to make investment decisions using he following rules:

• If appropriate discount rate > IRR, reject the investment (negative NPV).

• If appropriate discount rate < IRR, accept the investment (positive NPV).

• If appropriate discount rate = IRR, accept or reject the investment (NPV = 0)

8. IRR can be calculated by using a calculator (recommended for the exam) or by using a three-

step process.

9. IRR has several shortcomings that make it difficult to simply select the investment with the

highest IRR. These shortcomings include a failure t consider the risk of the investment, timing

of cash flows, size of cash flows, length of investment period, type of cash flows, suitability of

different discount rates, and financing risk.

10. The amortization of a real estate loan is a schedule of principal repayments.

• A zero-amortization loan repays no principal until the maturity of the loan.

• A fully amortized loan has a maturity and an amortization period that are equal. The

periodic payment is constant, but the proportion allocated to principal (interest)

increases (decreases) with each payment.

• The amortization period may be longer than the maturity of the loan.

11. The annual payment on a real estate loan may be calculated using annuity factors, a loan

constant table, or a calculator.

• Annuity factor method:

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• Loan constant method:

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12. As the amortization period of a loan decreases, principal payments increase, interest

payments decrease, and the tax shield from interest decreases. The net effect is a decrease

in after-tax cash flows. The reverse is true as well.

13. In a negative amortization loan, interest accrues over regular intervals during the accrual

period and is then added to the principal balance at the end of the accrual period. During the

accrual period, additional principal may also be borrowed.

14. Increased vacancy will cause a decrease in net base rental revenue, a decrease in ancillary

revenue, a decrease in overages (if retail space is vacant), and a decrease in reimbursed

expenses.

15. Total rental income is equal to gross potential income minus income lost to vacancy plus any

percentage rents (also called overages).

• Gross potential rent can be calculated using lease-by-lease analysis or using a

simplified formula:

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• Revenue lost to vacancy can be calculated as a percentage of gross potential rental

revenue or as expected vacant square footage multiplied by average base rent per

square foot.

• Percentage rents are a predetermined percentage of a retail lessee’s sales over a

certain level called the breakpoint.

16. Operating expenses can be calculated as the sum of the reimbursable expenses (common are

maintenance costs, property taxes, etc.) and non-reimbursable expenses (insurance, utilities,

management fees, etc.) necessary for day-to-day operations.

17. Net operating income is equal to total operating income minus total operating expenses.

18. Tenant improvements (TIs) are modifications or upgrades made to rental space to suit the

tenant’s operational requirements. A portion of the cost of TIs may be incurred by the property

owner.

19. Capital expenditures (cap ex) are large capital outlays to update and repair the property in

order to remain competitive. The cost of cap ex is borne by the property owner.

20. Depreciation is calculated using the following formula:

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• Depreciable life is determined by the category the asset falls into: 27.5 years for

residential structures, 39 years for other structures, and three to seven years for

improvements.

• TIs are depreciated by half in the first year, and the other half is amortized for the

lease term.

• Cap ex is treated as an improvement (three to seven years).

21. Leverage decreases the cash flow available to equity holders and increases the risk of the

cash flows. There is a tax savings resulting from interest an loan point amortization, but the

requisite debt service results in a net decrease in cash flow to equity.

22. Company analysis begins with a roll up of the individual properties held by a company but

then extends to include company-level items not reflected in the properties such as corporate

general and administrative expenses, corporate capital expenditures and depreciation,

corporate debt, and corporate income not derived from real estate assets.

23. The value of a real estate company will be greater than the value of its properties if competent

management successfully undertakes value-added initiatives and will be less than the value of

its properties if incompetent management undertakes value-destroying initiatives.

24. The value of a real estate company can be calculated sing three approaches:

• The discounted cash flow approach uses the following formula to determine company

value:

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• Cash flows are defined as follows:

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• The cap rate approach assumes cash flows are already stabilized and uses the

following formula to calculate company value:

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• The net asset value approach assumes that management adds no value and sums

the capitalized values of the income from properties and management or fee-related

services and the values of the development business, raw land, and the cash position.

Total debt and liabilities are subtracted to determine the net asset (i.e., equity) value.

Property income is capitalized using the cap rate approach with a market observed

discount rate. Income from management or fee-related services is capitalized using

market observed multiples.

25. Net asset value calculations are highly sensitive to the cap rate since it is used to value the

largest asset owned by the company, its property portfolio. Small cap rate changes lead to

large property value and net asset value changes.

17. Debt and Mortgages

1. Several ratios are used to measure the ability of the borrower to meet debt obligations (i.e., to

assess the risk of the loan):

• The loan-to-value ratio (LTV) is the remaining balance of the loan divided by the

(market) value of the property.

• The interest coverage ratio, calculated as the property’s net operating income (NOI)

divided by the amount of annual interest payable.

• The debt service coverage ratio (DSCR) is calculated as the property’s NOI divided by

the total loan payment, including interest and principal.

• The fixed charges ratio is yet another way of measuring the ability of the owners (i.e.,

the property) to meet their financial obligations.

2. A positive loan covenant is something the borrower must do, such as maintain the property. A

negative loan covenant is something the borrower cannot do, such as pay dividends before

interest is paid.

3. Other real estate loan terms include:

• The loan’s maturity and rate of interest.

• Whether the loan is fully or partially amortized (balloon payment) or is interest-only.

• The payment dates.

• Any primary and secondary assets the lender can claim in the event of default

(recourse).

• The creditor’s right to sweep cash flows.

• When and how the owner can make draws on a construction loan.

• The proportion of leases that must be signed (rental properties) before the loan is

made.

4. The primary benefits of refinancing include lower interest rates and the ability to withdraw

funds from the project. Costs of refinancing include loan origination fees (points) and

prepayment penalties. Opportunity costs include time spent in making the refinancing

decision. Another consideration is the new loan covenants.

5. There are at least four situations under which refinancing a loan is worthwhile:

• Interest rates have fallen enough to warrant paying the prepayment penalty (if

replicable) and other costs.

• Owners are able to withdraw capital tax-free.

• Creditworthiness has increased dramatically, and you are now able to borrow at

significantly lower rates.

• Originally lender willing to waive the prepayment penalty to avoid losing you to a

competitor.

6. To make the process more efficient, every participant in the CMBS process specializes in the

area in which they have the greatest skills and experience. The CMBS pool originator

assembles the loans and markets the pool. The CMBS are issued by an SPC. The master

servicer services the loans, and the special servicer handles loans that are in default or

foreclosure.

7. A pool of fixed-rate loans with different characteristics is known as a fixed-rate fusion pool.

Conduit loans are smaller loans that are originated with the intent of placing them in a CMBS

pool. In a net credit lease (a.k.a. closed-end lease), the tenant (the lessee) pays all expenses

related to operating the asset or property (i.e., the expenses normally associated with

ownership). The risk inherent in CMBS is determined by the creditworthiness of the borrower.

8. The loans in a CMBS pool are separated into classes known as tranches. Some tranches may

be interest-only tranches, while others can have claims on the repayment of principal. The

tranches can pay fixed or floating rates.

9. Rating agencies assess the risk-associated with each tranche and give each a rating. Rating

agencies play an integral role in the CMBS process in providing risk assessment mechanism

for investors while maximizing the price received by the loan originators.

10. Due to the resulting specialized cash flows, investors might be willing to pay a premium for a

tranche’s cash flows.

11. The risk of a CMBS pool or a single tranche can be assessed by looking at the loan-to-value

ratio (LTV), the interest coverage ratio, the debt service coverage ratio (DSCR) (i.e., the

percent of loans in default), or the composition of the tranches.

18. Real Estate Returns

1. Capital gains taxes are paid on the increase in the value of the property. Recaptured

depreciation is the amount of depreciation that was taken since the property was purchased

that is taxed when the property is sold.

2. Real estate exit strategies include selling, refinancing, like-kind exchange, trading for an

interest in a public company, and going public.

3. Real estate private equity funds are typically structured as limited partnerships, with the fund

sponsor serving as the general partner.

4. Pref is the preferred IRR on invested funds. The money refers to the cash invested in the fund,

so money contributed by the fund sponsor is considered part of the money. Cash waterfall is

the name given to the cash flows (profits) generated by the private equity fund and how they

are divided among the money. Profits paid to the sponsor are referred to as the sponsor’s

promote or carried interest.

5. The most common cash waterfall divides all profits 80/20 as long as the pref is earned. In an

alternative method the 80/20 split only applies to profits in excess of the pref.

6. Real estate cycles are driven by supply and demand imbalances. Unlike most consumer

products or financial assets, the real estate market can take years to return to supply and

demand equilibrium.

7. The real estate market can take years to return too supply and demand equilibrium because it

can take years to plan, raise funds, and build an office building or other commercial real estate

property.

8. The rate at which over-supply is corrected (i.e., the rate at which vacant properties are

utilized) is referred to as the absorption rate, which is influenced by the information lag (the

time it takes to collect and organize data) and regulatory approvals (e.g., rezoning).

9. The Wharton Real Estate Index shows the supply of real estate capital relative to demand. An

index value of 100 is used to approximate equilibrium conditions. A value over (less than) 100

indicates excess (insufficient) supply compared to demand.

10. Although there isn’t technically a “national” real estate market, forecasting real estate trends

on a national level is less difficult than on a local or regional basis.

11. The National Council of Real Estate Investment Fiduciaries (NCREIF) Index shows quarterly

(unleveraged) real estate returns based on annual appraisals of core properties. Returns,

typically in the high single digits, are less volatile than the NAREIT Index returns.

12. The National Association of Real Estate Investment Trusts (NAREIT) Index uses transaction

data to generate returns, usually in the 10% to 12% range, for publicly traded REITs, which

invest in high quality properties. Since REITs employ leverage in their purchases, index

returns reflect a moderate (~50%) use of leverage.

13. Using either the NAREIT or NCREIF Index as a stand-alone benchmark for private equity

funds is inappropriate. However, these indices may be combined with a fixed rate to create a

suitable benchmark.

14. Private equity funds should earn approximately 7% above the NAREIT and 10% above the

NCREIF.

19. Introduction to Hedge Funds

• Are private investment vehicles for sophisticated investors.

• Have concentrated portfolios with a fewer number of holdings.

• Use derivatives more frequently

• May take long or short positions in securities.

• Use leverage, sometimes in large amounts

• Invest in private placement securities.

2. There are four primary categories of hedge funds:

• Market directional funds have some degree of market risk exposure that causes the

fund o be impacted by market conditions.

• Corporate restructuring funds attempt to profit from corporate events such as

bankruptcies and mergers.

• Convergence trading strategies take offsetting long and short positions in similar

securities to profit from a narrowing of the spread between the two securities.

• Opportunistic strategies try to take advantage of whatever opportunities may be

present in the marketplace.

3. Equity long/short strategies combine long stock positions with short positions to construct a

portfolio with reduced exposure to market risk.

• The ability to go both long and short opens up the opportunity to gain regardless of

market direction.

• Fundamental equity long/short strategies analyze the business prospects of

companies within an industry from a bottom-up perspective.

• Quantitative equity long/short strategies use complex multifactor modules to select

securities

• Weighted average beta = (w1 × ß1) + (w2 × ß2) + … + (wn × ßn)

4. Market timing strategies rely on the analysis of macro economic factors and attempt to be fully

invested in the market (long) when the market is rising and stay in cash when the market is

falling.

• Market timers rely on top-down analysis, rather than the bottom-up approach of equity

long/short managers.

• Market timers eliminate unsystematic risk exposure and use stock index futures to

determine when to add systematic risk exposure. Equity long/short funds exploit

unsystematic risk and eliminate systematic exposure.

5. Short-selling strategies maintain a net short exposure to the market and attempt to profit from

market declines.

• The market exposure is exactly opposite that of traditional long-only manager.

• Unlike equity long/short managers who typically maintain a net long exposure, short-

selling managers tend to maintain a net short strategy.

6. Distressed security strategies invest in the securities of companies that are bankrupt or are

likely to go bankrupt.

• Capital structure arbitrage is a form of a distressed security strategy that is based on

the hierarchy of claims in a bankruptcy liquidation.

• There is an overlap with private equity investing when distressed security hedge funds

purchase undervalued securities that may appreciate as a result of the bankruptcy

reorganization process.

7. Merger arbitrage involves purchasing the stock of a firm that is the target of a takeover and

selling the stock of the acquiring firm in an attempt to capture the spread between the pre-

merger and post-merger prices of the companies.

• The main sources of return include the (positive) change in value of the target firm

and the (negative) change in value of the acquiring firm.

8. Event-driven strategies attempt to profit from mispricings associated with one-time company-

specific events. The main source of return is from the accurate prediction of the occurrence of

an event within the given time frame of the investment.

9. Fixed-income arbitrage strategies involves taking a long position in one fixed-income security,

a short position in a related fixed-income security, and profiting as the spread between the two

securities converges over time.

• Any type of fixed income security may be used in the execution of the strategy.

• The sources of return come from spread trades (exploiting differences in price

between two otherwise identical securities) and yield curve trades (exploiting

changes in the slope of the yield curve).

• Mortgage-backed security arbitrage strategies attempt to capitalize on pricing

discrepancies in the MBS market.

• The main risk exposures for MBS include duration, convexity, yield curve rotation,

prepayment risk, credit risk, and liquidity risk.

10. Convertible bond arbitrage strategies consist of going long in the company’s convertible bonds

and hedging the associated equity exposure by taking a short position in the company’s

common stock.

• The hedge ratio (delta) determines the appropriate mix of convertible bonds to short

positions in the underlying stock.

• The components of total return include interest on the bonds, short rebate, change in

the value of the bond net, the change in the value of the underlying stock, and interest

on borrowing.

• The main risk exposures are leverage, liquidity risk, interest rate risk, model risk,

credit risk, call risk, and event risk.

• The number of shares that we need to short sell to delta hedge a position is calculated

as:

Shares of stock = number of convertible bonds × conversion ratio × hedge ratio

11. Market neutral strategies take long and short positions securities with the goal of eliminating

all market risk, leaving security selection as the sole source of return.

• The rule of one alpha says that there is only one source of risk-adjusted return.

• Dollar neutral refers to holding equal amounts of long and short positions so the

manager has a zero net exposure to the market.

• Factor models are complex regression equations that relate security returns to one or

more specific variables.

12. Statistical arbitrage strategies rely on complex quantitative models to create convergence

trade portfolios.

• Statistical arbitrage strategies are often called black boxes because they lack

transparency.

13. Relative-value arbitrage is a broad term that describes any strategy that attempts to profit from

a relative mispricing between two securities.

• Market risk can be removed by holding a long position in one security and a short

position in a similar security.

• Stub-trading strategies are stock-based strategies that involve the piece of an equity

security that is left over from a merger or recapitalization.

• Volatility arbitrage strategies attempt to capitalize on differences in the implied

volatility that exists between option prices on a particular stock.

14. Global macro strategies look for opportunities anywhere in the world and will invest in any

country or any type of security. Global macro managers have the most extensive investment

universe of any manager in that they can invest in anything, anywhere.

15. Funds of funds are opportunistic strategies that invest in portfolios of various hedge funds

• The advantage to a fund of funds is reduced risk as the result of diversification. The

disadvantage to a fund of funds is a double layer of fees for the investor.

20. Establishing a Hedge Fund Investment Program

1. Research on historical performance covering the period from 1989 to 2000 indicates that

hedge funds have consistent positive performance, although not all hedge fund categories

outperformed the S&P 500.

2. Hedge funds generally have less volatility, as measured by standard deviation, than the S&P

500.

3. Studies found that adding hedge funds to a broad stock market based portfolio was found to

increase returns and reduce risk.

4. Hedge funds exhibit low correlation with traditional asset classes, which indicates that adding

hedge funds to a portfolio offers significant diversification benefits.

5. The academic evidence on hedge fund performance has the following drawbacks:

• Majority of studies only covered a 6-year timeframe and did not include performance

in a variety of economic environments. Since this time, the hedge fund industry has

grown exponentially.

• Studies took place before the downfall of LTCM, which showed that shocks to one

hedge fund strategy affect other hedge fund strategies as well.

• Results from performance databases have survivorship, catastrophe, and self-

selection biases which serve to bias reported performance higher and measured

downside volatility lower.

6. Studies concerning performance persistency had mixed results.

7. Hedge funds do not cause financial market calamities but may exacerbate the magnitude of a

market decline.

8. Two primary goals of a hedge fund investment program are to increase return and decrease

risk.

9. An opportunistic hedge fund investment program seeks to expand the investment opportunity

set for money managers.

10. Two primary goals of an opportunistic hedge fund investment program are to add value to an

existing investment program through specialization and fill gaps in the investment spectrum of

an existing portfolio.

11. A hedge fund of funds program combines a portfolio of individual hedge funds in an effort to

diversify away the idiosyncratic risk from any one manager.

12. Hedge fund of funds experience declining marginal diversification benefits after five individual

funds.

13. Risk budgeting is the process of defining an acceptable amount of risk and then allocating that

risk across a portfolio.

14. Hedge funds tend to be a useful tool for risk budgeting as a result of their low standard

deviation and low correlation with traditional asset classes.

15. Given a risk budget and the standard deviation and correlation between two assets,

appropriate asset class weightings for risk budgeting purposes can be found through the

following formula:

expected rate of return is greater than the hurdle rate, the asset class will be a useful tool for

risk budgeting.

17. A portable alpha strategy is a way to transport the alpha from hedge fund of funds investment

to another asset class by investing directly in the fund of funds and using futures contracts to

gain the desired asset class exposure.

18. A hedge fund of funds can be an effective replacement for either cash or bonds in an

efficiently allocated portfolio.

19. Absolute return hedge fund strategies attempt to earn positive returns regardless of the

direction of the financial markets.

21. Due Diligence

1. Due diligence is a disciplined approach for finding the best possible hedge fund manager. The

due diligence process consists of seven parts:

• Structure of the hedge fund

• Investment strategy review

• Performance review

• Risk assessment

• Administrative review

• Legal review

• Checking references

2. Three fundamental questions to ask in order to understand a hedge fund’s investment

program are the following:

• What is the hedge fund manager’s investment objective?

• What is the hedge fund manager’s investment process?

• What is the hedge fund manager’s competitive advantage?

3. Three essential questions for understanding a hedge fund manager’s investment process are

the following:

• What is the hedge fund manager’s investment universe?

• What is the general investment strategy of the hedge fund?

• Does the hedge fund manager have a benchmark, and if so, what is it?

4. A black box investment process uses a quantitative computer algorithm preprogrammed by

the fund manager to make investment decisions.

5. Process risk is an unquantifiable idiosyncratic risk of the fund manager’s structure and

operations.

6. Hedge funds gain a competitive advantage through their ability to either filter or gather

information.

7. The structural review phase of the due diligence process allows an investor to define how the

hedge fund is organized as a business entity.

8. A master trust structure is used to invest a hedge fund’s assets in a way that accommodates

the various tax domiciles of the fund’s domestic and foreign investors.

9. A master trust structure has no direct tax consequences, which allows any tax liability

associated with investing in a hedge fund to fall under the tax code of each investor’s home

country.

10. To identify how a hedge fund is organized, an investor should ask the following questions:

• Where is the hedge fund manger located?

• May I see an organization chart of key personnel?

• What is the educational background and prior experience of the firm’s principals?

• How did you learn to short stocks?

11. The CFO of a hedge fund is responsible for reporting the fund manager’s performance results

to investors.

12. An investor needs to know who owns the hedge fund manager in order to assure that

contracts are being signed with the right key people and that interests are aligned effectively

between the fund manager and its employees.

13. In the United States, common regulatory registrations are with the SEC and the NFA/CFTC.

14. Important outside service providers to hedge fund managers are outside auditors, prime

brokers, and legal counsel.

15. Prime brokers are responsible for executing trades, lending securities to sell short, and

providing the means for the hedge fund to leverage its positions.

16. A hedge fund’s investment style, the target markets a manager invests in, and the type of

securities a manager invests in should be documented in order to fully understand the

manager’s investment strategy.

17. A short volatility strategy involves taking short positions in call or put options so that rising

volatility in the price of the underlying security exposes the investor to the risk that the options

could be exercised against the investor.

18. Passive benchmarks are difficult to use for evaluating hedge fund performance because:

• Passive benchmarks are ineffective for measuring the level of a manager’s skill.

• Hedge fund strategies such as a long/short strategy cannot be captured by a long-

only benchmark.

• Concentrated portfolios look much different than broad-based security benchmarks.

19. Hurdle rates are appropriate measures of performance for absolute return hedge funds whose

returns do not relate to the performance of any one sector or market.

20. A portfolio snapshot lets a potential investor see exactly what positions a manager is currently

holding in the hedge fund portfolio and gives insight into the manager’s strategy.

21. The process used for idea generation is a key component of a hedge fund’s competitive

advantage and is reflective of the hedge fund manager’s skill.

22. Capacity refers to the amount of assets under management a hedge fund manager can

handle and still implement the fund’s investment strategy effectively.

23. Three relevant questions to ask when reviewing a hedge fund manager’s performance are the

following:

• How long has the hedge fund manager been actively managing a hedge fund?

• Have performance results of the fund shown persistency over time?

• Are performance results the same or different for each hedge fund the manager

manages?

24. Drawdown refers to a decline in the NAV of a hedge fund.

25. Drawdowns in long-only investments can be attributed to a decline in the market; however,

drawdowns in hedge funds can only be attributed to a loss of fund manager skill.

26. Withdrawals can have a harmful effect on hedge fund performance by triggering transaction

costs and skewing the asset allocation of the hedge fund portfolio.

27. Three relevant questions for the risk review phase of due diligence analysis are the following:

• What risks are managed by the fund manager?

• How does the fund manager measure risk?

• How does the fund manager manage risk?

28. Active risk is defined as the standard deviation of the difference between portfolio returns and

the returns of a benchmark.

29. Short volatility risk refers to the risk that rising volatility in the prices of underlying securities

could cause short call or put options to be exercised against the fund manager.

30. Counterparty risk is the risk that the person on the other side of a derivative transaction will

default on the agreement.

31. Leverage limits are an effort to limit risk by placing an upper bound on the amount of leverage

a hedge fund manager can use.

32. The administrative review phase of the due diligence process looks at operational issues that

may impact the hedge fund manager and the manager’s relationship with clients.

33. Employee turnover forces a hedge fund manager to spend time and resources finding and

training new employees and is a distraction to the risk management process.

34. The account representative is the investor’s link for handling issues related to setting up

meetings, handling withdrawal requests, processing checks, and conveying performance

information.

35. Disaster planning gives the hedge fund manager a course of action for continuing to manage

the fund in the event that a disaster shuts down a fund’s trading and operations.

36. The limited partnership structure of a hedge fund requires the manager to invest alongside

investors, thus aligning manager and investor interests. Limited partners are at risk in a hedge

fund only to the extent of capital they have invested in the fund.

37. Separate accounts lack the advantages of the limited partnership structure but serce to

eliminate concerns related to withdrawals and proportionate gain/loss reporting.

38. A 2 and 20 fee structure means that the manager receives a consistent 2% management fee

plus 20% of all profits generated by the fund.

39. Having a high watermark means that a fund manager cannot receive a profit-sharing fee until

the manager exceeds the highest NAV for the fund during the previous performance reporting

period.

40. An incentive fee gives the fund manager an incentive to make profits for investors by allowing

the manager to share in a percentage of those profits.

41. Clawbacks allow investors in a hedge fund to take back incentive fees previously received by

the fund manager.

42. A lock-up period refers to a set period of time that an investor’s funds must remain with a

hedge fund.

43. Having a lock-up period is advantageous to investors because it (1) gives the fund manager

time to implement the investment strategy without worrying about redemptions and (2)

temporarily eliminates the problem of transaction costs caused by withdrawals.

44. A notice period refers to a certain period (30 to 90 days) of advance warning for the fund

manager that an investor wants to make a withdrawal.

45. High subscription amounts give the hedge fund manager adequate capital to implement the

fund’s investment strategy and ensure that only sophisticated investors that have a large net

worth invest in the fund.

46. Maximum subscription amounts prevent one investor from having too large of a position in the

fund and can help manage capacity constraints with regard to assets under management.

47. Potential sources of due diligence reference checks include primary service providers and

existing clients.

48. Asking questions to existing hedge fund clients gives an idea of the manager’s quality of

services and can uncover any issues the clients may have that cause dissatisfaction with the

fund manager.

22. Risk Management

1. Academic studies have found that the returns on hedge funds are more affected by the

actions of the manager than by the market. The lack of correlation with traditional financial

assets means that adding hedge funds to an already diversified portfolio can reduce risk and

increase returns.

• Sharpe (1992) reports that traditional asset classes explain about 90% of mutual fund

returns.

• Fung and Hsieh (1997) find that traditional asset classes explain approximately 25%

of the variability in hedge fund returns, while hedge fund trading styles explain

approximately 45%.

• Fung and Hsieh (2002) report a large range for R-squares for mapping hedge fund

returns to traditional long only indices, which indicates that traditional mean variance

analysis does not fully capture the return distribution.

• Liang (1999) reports that asset class selection is responsible for 77% of the returns for

emerging markets’ hedge funds but only 20% of the returns for foreign exchange

hedge funds.

• Schneeweis and Spurgin (1998) report that asset classes explain about 67% of the

returns of hedge funds with primarily a long equity strategy and almost zero for

relative value hedge funds. This supports the perception that hedge fund returns are

driven more by the managers’ trading styles than by traditional asset classes.

2. The major risk affecting market directional funds is exposure to the stock market. Market

directional funds include the following strategies: equity long/short, short selling, equity market

timing.

3. The major risk of the corporate restructuring funds is the failure of the proposed transaction

(i.e., event risk). Corporate restructuring funds include the following strategies: distressed

securities, merger arbitrage, and event driven.

4. Like corporate restructuring funds, the major risk of convergence trading funds is event risk.

The event for these types of funds is that the prices of two similar securities will converge over

time. Convergence trading fund strategies include fixed-income arbitrage, convertible bond

arbitrage, equity market neutral, statistical arbitrage, and relative value arbitrage.

5. Because opportunistic funds invest in a broad spectrum of investment vehicles, they should be

more diversified than other hedge fund strategies. The major risk is that the hedge fund

manager is not able to create a diversified portfolio and that the return distribution will be

negatively skewed and leptokurtic. Opportunistic funds include global macro strategies and

fund of funds strategies.

6. Convergence trading and corporate restructuring funds are exposed to event risk and

therefore should have large downside risk exposure that is reflected in a distribution that is

negatively skewed with fat tails (leptokurtic).

7. Convergence trading and corporate restructuring funds should exhibit return distributions that

are negatively with fat tails. Funds that minimize market and credit risk exposure (equity

market timing and market neutral strategies) should have low values for skewness and

kurtosis.

8. All three market discretional hedge funds return distributions exhibit positive skewness, which

is an indicator of management skill. Both the equity long/short and short-seller indices have a

value for kurtosis that is greater than the market index, while the market timing index value for

kurtosis is negative (platykurtic). The long-only manager has one source of alpha – the ability

to identify underpriced investments to purchase. Likewise, the short-only manager has one

source of alpha – the ability to identify overpriced investments to short. The long-short

manager thus pursues a double alpha strategy by identifying overpriced investments to sell

short and underpriced investments to purchase.

9. The funds with corporate restructuring strategies are all negatively skewed and leptokurtic.

The funds with merger arbitrage strategies have more consistent returns but are also greatly

impacted when the proposed transactions fail to occur (i.e., highest value of kurtosis of all

hedge fund strategies).

10. All of the convergence trading funds have consistent returns in the 0% to 2% range. The fixed-

income arbitrage and relative value strategies are exposed to high amounts of event risk,

while the market neutral funds have very little event exposure and are positively skewed.

11. Global macro funds and FOF fund are able to diversify across broad spectrums of

investments. The global macro managers have been able to produce returns that are

positively skewed with lower values of kurtosis, whereas the returns of FOF managers were

negatively skewed and had fat tails.

12. Market directional hedge fund strategies (equity long/short, short sellers, and market timers)

have positively skewed returns and also are exposed to the most market risk.

13. The equity long/short hedge fund managers expose investors to slightly more event risk than

the S&P 500, but with positive skewness. The hedge funds of market timers exhibit positive

skewness and negative kurtosis. Therefore, market timers are able to reduce event risk. The

hedge funds of short sellers also exhibit positive skewness but have the most volatility and a

negative Sharpe ratio.

14. Most of the convergence trading and the corporate restructuring types of funds are exposed to

event risk. The event risk to these funds is similar to that of an insurance company selling

insurance. That is, insurance companies are able to keep the premium from selling insurance

unless the event that is being insured happens.

15. The convergence trading and corporate restructuring funds have a known upside return;

however, the downside outcome can occur if some event prevents the transaction or the price

convergence to occur. Therefore, these strategies are like selling insurance or selling a put

option.

16. The equity market neutral and equity market timing hedge fund strategies have very low

market risk and insurance risk. Both strategies have very low values for skewness and

kurtosis. The low values for kurtosis indicate that the insurance risk or event risk is very low.

17. Process risk is the inability to examine, understand, or even determine the process used by

the hedge fund manager in selecting investments. Process risk is associated with the manner

in which investments are selected. Just like the unsystematic risk of common stocks, process

risk can be managed by diversifying across several hedge fund managers. Studies by Park

and Staum and by Henker find that investors who combine 15 to 20 hedge funds eliminate

about 95% of the process risk.

18. Mapping risk is the uncertainty associated with determining and measuring sources of risk

because the manger’s strategies and positions are unknown. A suggested solution is for the

hedge fund manager to report the information to a central prime broker, who would

accumulate and report the data without including the names of the specific managers..

19. Transparency risk is the inability to know the trading patterns of a hedge fund manager.

20. There are three potential problems associated with lack of transparency:

• Authenticity

• Monitoring and measuring

• Determining the effect on total portfolio risk of including an allocation to hedge funds

21. Value at risk (VaR) is defined as the maximum loss over a period of time at a given level of

significance.

22. Risk management risk is the risk that risk is being measured and managed incorrectly.

23. There are four primary concerns with applying VaR to hedge funds:

• VaR is difficult to compare across hedge funds

• VaR is not additive

• VaR assumes normally distributed returns

• VaR is the maximum loss given normal market conditions.

24. There is data risk associated with academic studies caused by the prime period and

techniques used by the researchers when

• The studies were performed

• There is no comprehensive database

• The hedge funds index data are inherently biased

• Survivorship bias exists

25. Selection bias refers to the effect of voluntary reporting (i.e., there is a tendency for only funds

with positive results to report). Backfill bias refers to the inclusion of the fund’s historical

(positive) performance when I is added to the index. Catastrophe/liquidation bias refers to the

positive bias associated with the withdrawal from the index of funds that start performing

poorly or sense that they will have to liquidate.

26. Performance measurement risk refers to the inability to accurately measure and, hence,

forecast risk-adjusted performance.

27. Because it is biased on normal distributional properties, the Sharpe ratio does not capture the

event risk associated with hedge funds.

28. Short volatility bias is the result of selling derivatives, which inflates Sharpe ratios by adding

cash and reducing volatility.

29. A volatility event is any event that causes the manager to experience losses from shorting

derivatives, such as call or out options being exercised against the manager

30. Event risk is the risk that a portfolio’s value can be affected by large jumps in market prices.

31. Liquidity risk refers to the hedge fund manager’s inability to raise cash at reasonable rates or

sell assets at regular market prices to meet immediate cash needs.

32. Beta expansion risk occurs when a hedge fund has greater sensitivity to downward market

movements than upward market movements due to selling pressure that results from multiple

managers shorting the same security.

33. Short volatility risk refers to the risk that rising volatility in underlying securities could cause

short put option positions to be exercised against the fund manager. The returns o corporate

restructuring hedge fund strategies tend to suffer when market volatility increases indicating

exposure to short volatility risk.

34. Multimoment optimization incorporates skewness and kurtosis into portfolio optimization

analysis in order to capture the off-balance-sheet risk of the hedge fund manager.

35. Headline risk refers to the fact that the lack of transparency and potential for high returns from

hedge funds make investors susceptible to stories of great returns from fraudulent managers

who want to collect high fees.

23. Regulation of Hedge Funds

• The act contains two key provisions that apply to hedge funds. The first provision

requires that a registration statement be filed out with the SEC prior to the initial sale,

and the second provides for exceptions to the registration requirement.

• A limited partnership unit of a hedge fund is considered a security.

• The SEC does not “approve” a registration statement. Rather, a registration statement

is declared “effective” by the SEC when all material information has been disclosed.

• Section 4 of the 1933 Act provides an exemption from the SEC registration process

for private offerings (e.g., hedge fund partnership units)

• Regulation D provides conditions for exemption for hedge funds from SEC filing;

however, it does not provide a safe harbor from antifraud provisions.

• Two key provisions in Rule 501 are the calculation of the number of investors and the

definition of an accredited investor. Rule 506 states that to be exempt from SEC

regulation, there cannot be more than non-accredited purchases or securities. The

number of accredited investors is not limited. Accredited investors are large

institutional investors or high net worth individuals.

• Rule 502 includes an integration provision that states that all sales that are part of the

same offering must comply with all provisions of Regulation D.

• Section 17 subjects hedge fund managers to the anti-fraud provisions, regardless if

the hedge fund is offered as a public of a private offering.

2. The Securities Exchange Act of 1934 applies to hedge funds. The 1934 Act

• Created the SEC as the regulatory body to enforce security laws

• Created regulations and required that all broker-dealers register with the SEC

• Established rules for the secondary trading of securities, including transactions

involving hedge funds. Rule 10b-5 subjects transactions between investors to the

same antifraud standards that the hedge fund issuers are required to follow.

3. The Investment Company Act of 1994 applies to hedge funds.

• “3(c)(1) funds” are exempt from registering with the SEC as long as there are 100 or

less investors in the fund.

• As long as there are less than 500 qualified purchasers in the fund, “3(c)(7) funds” can

avoid the registration and reporting requirements of mutual funds. Section 12(g)(1)

limits the number of investors to 499 for “3(c)(7) funds”.

• The 1996 amendment to the Investment Company Act of 1940 defined qualified

purchasers as:

o A natural person (including a qualified spouse) who owns at least $5 million of

investments.

o Owners of a family business who directly or indirectly own at least $5 million.

o Trusts that are not formed for the sole purpose of acquiring securities.

o Any other person who owns or acts for another qualified purchaser who owns

and invests at least $25 million on a discretionary basis.

4. The Investment Advisers Act of 1940 applies to hedge funds.

• Under Section 203(a), an investment adviser can avoid registering with the SEC if he

does not manage more than $25 million, and if he is not an adviser to a mutual fund.

• Under Section 203(b), an investment adviser can avoid registering with the SEC if he

has managed less than 15 clients during the previous 12 months.

• Under section 206, all investment advisers are subject to the antifraud provisions of

the Investment Advisers Act of 1940.

5. The changes to Section 203(b) were intended to increase the regulation of hedge funds.

•Under Section 203(b), an investment advisor can avoid registering with the SEC if the

new advisor has managed less than 15 clients during the previous 12 months. The

new rule requires that each investor in a hedge fund counts as a client. Since most

hedge funds have more than 14 investors, most hedge managers will have to register

as investment advisors.

• The new rule follows for an investment advisor to avoid registering with the SEC if the

advisor does not manage more than $25 million and if he is not an advisor to a mutual

fund. A fund also qualifies for an exemption if it requires a lock-up process of at least

two years.

• The SEC lists four benefits to the more rigorous registration requirements under Rule

203(b)(3)-1 and Rule 203(b)(3)-2:

o Providing census information on hedge funds.

o Deterring fraud.

o Strengthening internal controls.

o Improved monitoring of industry growth and practices.

• Two practical implications associated with the new rule are:

o The costs of a chief compliance officer and other internal controls should not

be a burden to hedge funds due to the large fees charged by hedge funds.

o As more hedge funds adopt 2-year lock-up provisions, the liquidity of

investors is reduced, as well as the ability of regulators to track and regulate

the industry.

6. The Commodity Exchange Act (CEA) applies to hedge funds.

• The rules that relate to Commodity Pool Operators (CPOs) are most relevant to hedge

funds. Managers of hedge funds who are CPOs must register with the Commodity

Futures Trading Commission (CFTC) and the National Futures Association (NFA). In

addition to disclosure, reporting, record keeping, and performance disclosures,

registered CPOs are also subject to audits by the CFTC.

• A CPO is any individual or firm that invests the collective money of a group in the

commodity futures and/or options markets.

• Although there are numerous provisions in the CEA that exempt hedge funds from

filing annual reports, all hedge fund managers are subject to the antifraud provisions

of the CEA.

o Under Section 4.5, hedge funds are exempt from registration if the entity is

subject to regulation by another federal jurisdiction.

o Under Section 4.13(a), a CPO is exempt from registration if he

Does not receive compensation from the pool

Only operates one pool

Does not advertise the pool

Is not required to register under other provisions of CEA.

o Under Section 4.13(b), a CPO is exempt from registration if

The total contributions are less than $200,000

There are no more than 15 participants in the pool

o Under Section 4.7, CPOs must register and file annual reports with the CFTC

and NFA; however, the CPO is exempt from disclosure, reporting, and record-

keeping requirements. This exemption requires that the hedge fund only sell

to “Qualified Eligible Participants” (QEPs) and that it files with the CFTC a

notice of claim for exemption.

o QEPs include most institutional investors (e.g., banks, broker-dealers, other

CPOs, Commodity Trading Advisors, insurance companies, pension plans).

Individuals are considered QEPs if they are accredited investors as defined

under Regulation D, have an investment portfolio of at least $2 million, or

have $200,000 on deposit with a futures commission merchant.

7. The President’s Working Group on Financial Markets made several recommendations for

financial institutions’ risk management practices:

• Establish a procedure to monitor and measure counterparty risk.

• Limit credit exposure to or by any one institution.

• Institute programs to mitigate credit risk

• Define standard valuation practices for derivative securities

• Develop techniques to integrate credit risk and market risk

8. The President’s Working Group on Financial Markets made several recommendations for

enhanced regulatory overview:

• Expand the authority of the SEC, CFTC, and Treasury Department to monitor

counterparties, which would include hedge funds.

• Increasing the risk assessment authority of the SEC and CFTC for unregulated

affiliates of broker dealers and Futures Commission Merchants (FCMs) and the

holding companies they form.

• Requiring reports to credit risk by counterparty for broker dealers, FCM, and their

unregulated affiliates.

9. The President’s Working Group on Financial Markets made several recommendations for

hedge funds:

• Improve transparency by increased frequency of disclosures.

• Publish a set of sound risk management practices.

• Assess performance relative to sound practices for investors and counterparties.

10. The Group of Five Hedge Funds made several recommendations for managing market risk:

• Measure market risk for each hedge fund portfolio and several relevant sub-

components.

• Stress test the impact of market conditions on market risk.

• Backtest the market risk models on historical data.

11. The Group of Five Hedge Funds made several recommendation for managing credit risk:

• Policies and procedures for managing, measuring, and monitoring the exposure to

potential default of counterparties.

• Appropriate levels of collateral and other credit support in the counterparty

agreements.

12. The Group of Five Hedge Funds made several recommendations for managing liquidity risk:

• Assessment of the impact of specific investment strategies, the terms of redemption

for hedge fund investors, and the liquidity of the assets in the portfolio.

• An evaluation of and borrowing capacity under the worst case historical conditions

and stressed market conditions.

• A forecast of liquidity requirements and likely changes to liquidity measures.

Risk Exposure for Hedge Fund Strategies and Statistical Summary

of monthly returns

Broad Hedge Fund Major Risk Mean Std. Skew Kurtosis Sharpe Comment(s)

Category Strategy Exposure Dev. Ratio

Market Long bias and double alpha

Market Equity

(double alpha 1.36% 2.55% 0.19 1.41 0.38 strategy may explain higher

directional: Long/Short

strategy) kurtosis

market

exposure – all High volatility (lack of

Opposite of

exhibit Short Selling 0.32% 6.10% 0.14 1.55 -0.01 consistency) contributes to

Market

positively negative Sharpe ratio

skewed Market

Equity Market Negative kurtosis indicates less

returns Minimal use of 1.03% 1.95% 0.09 -0.52 0.32

Timing exposure to outliers

leverage

Event risk:

Distressed ultimate credit Volatility is lower than high yield

1.21% 1.75% -0.67 5.69 0.47

Corporate Security risk exposure bonds

Restructuring: (bankruptcy)

event risk from Use of leverage magnifies the

Event risk and

short volatility impact of outliers, but returns

Merger Arbitrage use of 0.82% 1.22% -2.63% 11.64 0.34

strategies are consistent with 76%

leverage

results in between 0% and 2%

negatively Ability to invest in events other

skewed, than mergers results in smaller

Event risk and

leptokurtic kurtosis than merger arbitrage,

Event Driven use of 1.17% 1.89% -1.32 4.83 0.41

returns but returns are less consistent

leverage

with 50% of returns between 0%

and 2%

Event risk that

Negatively skewed with large

Fixed Income bond prices

0.68% 1.23% -1.72 10.60 0.23 value for kurtosis but with 72%

Arbitrage may not

of return between 0% and 2%

converge

Smaller value for kurtosis than

Event risk that

Convertible fixed income arbitrage – more

company 0.81% 1.03% -1.12 1.96 0.39

Arbitrage consistent with 78% of returns

Convergence redeems bond

between 0% and 2%

Trading: event

Minimize Positive values for skewness

risk from short

market & and low value for kurtosis –

volatility Equity Market

credit 0.74% 0.91% 0.17 0.38 0.38 minimal market and credit

strategies Neutral

exposure with exposure (i.e., all gains from

which are

zero beta security selection)

similar to

Quant models

writing a put

zero out other Low values for skewness and

option or

Statistical risk factors kurtosis. Similar to market

selling 0.69% 1.13% -0.06 0.50 0.26

Arbitrage (e.g., size, neutral strategy except decisions

insurance

growth, and are more model driven

which

momentum)

produces

Event risk

consistent

associated

returns

with short

Negatively skewed with a large

volatility

Relative Value value for kurtosis (leptokurtic).

strategy 0.95% 1.04% -0.83 10.51 0.53

Arbitrage Returns are consistent with 76%

magnified by

of returns between 0% and 2%

use of

leverage (e.g.,

LTCM)

Broad

investment Able to diversify across asset

spectrum classes and geographic scope.

Global Macro 1.25% 2.40% 0.36 0.57 0.35

creates Returns are close to normal with

Opportunistic:

diversified positive skew.

diversified so

portfolio

that returns

Investment in

are Although able to invest in variety

other hedge

symmetrical of hedge funds, the returns are

Hedge Fund of funds should

0.80% 1.61% -0.24 4.34 0.25 negatively skewed and

Funds create

leptokurtic, which is inconsistent

diversified

with expectations

portfolio

S & P 500 Long only 1.01% 4.40% 0.63 0.58 0.14 Negatively skewed

Comparative

Negatively skewed and

Indices: all SB High Yield Long only 0.75% 2.05% -0.81 4.16 0.17

leptokurtic

negative

Negatively skewed and

skewed HFRI Composite Not investable 1.13% 1.98% -0.61 2.90 0.37

leptokurtic

24. Introduction to Commodity Markets

• Cannot be valued based on discounted cash flows.

• Do not conform to asset pricing models such as the CAPM.

• Trade in a global, rather than regional marketplace.

2. Directly purchasing commodities is a difficult way to gain exposure due to the costs involved

with storing the commodity.

3. Buying shares of natural resource companies that derive the majority of their revenue from

buying and selling a particular commodity is considered a “pure play” on the price of the

commodity. In practice, pure play investments may not work due to market and company-

specific risk factors.

4. Commodity futures are considered the easiest way to gain economic exposure to commodities

because they:

• Trade on an organized exchange.

• Do not require the delivery of actual commodity to close a portion.

• Can be purchased on margin.

5. Commodity-linked notes combine commodity exposure with a traditional debt instrument.

6. The futures price is a no-arbitrage price. For a future of term T on an asset with no storage

costs or expected cash flows over the term of the contract, the futures price is:

7. Cash and carry arbitrage earns an arbitrage profit when the futures contract is overpriced

relative to the no-arbitrage price. It involves borrowing the money to buy the asset (and

holding it), selling the future, and delivering the asset to get the futures price, repaying the

loan, and keeping the difference as arbitrage profit.

8. Reverse cash and carry earns an arbitrage profit when the futures contract is underpriced.

The strategy is to short the asset, invest the proceeds, buy the future, take delivery at maturity

to cover the short, pay the futures price with the loan proceeds, and keep the difference as

arbitrage profit.

9. For a futures contract where the underlying asset pays a known dividend yield, the futures

price is:

10. The price for currency futures is based on interest rate parity, which says that the forward

exchange rate (F), measured in $/unit of foreign currency, must be related to the spot

exchange rate (S) and the interest rate differential between the U.S. and the foreign country

( ). For a foreign currency futures contract, the futures price is:

11. Storage costs increase the effective cost of commodity ownership. For a commodity futures

contract with storage costs, the futures price is

• if the storage costs are expressed as a known cash flow.

• if the costs are expressed as a continuous yield.

12. The convenience yield reflects a monetary or non-monetary benefit from holding a physical

asset. If a convenience yield, Y, is included in the futures pricing relationship, the futures price

is:

13. If a commodity futures contract is overpriced, cash and carry arbitrage can be used to exploit

the arbitrage opportunity. The difficulty in short-selling commodities makes exploiting

undervalued futures prices through reverse cash and carry arbitrage virtually impossible.

14. Normal backwardation refers to a price pattern where the futures price is below the expected

future spot price and converges to that price from below over time.

15. Contango refers to a price pattern where the futures price is above the expected future spot

price and converges to that price from above over time.

16. Hedging allows commodity producers and users to separate their commodity price risk from

their business risk and deploy capital more effectively.

17. The role of speculators in the commodity markets is to accept the price risk that hedgers are

unwilling to bear.

18. Backwardated commodity markets result from hedgers being net short futures contracts.

Hedgers are willing to sell futures contracts at a discount in order to coax speculators to take

the long position in a trade.

19. Contango commodity markets result from hedgers being net long futures contracts. Hedgers

are willing to buy futures contracts at a premium in order to coax speculators to take the short

position in a trade.

20. Speculators are compensated by receiving the discount or premium that hedgers give up

when trading futures contracts.

21. Commodities have a negative correlation with stocks and bonds, which has important

implications for portfolio construction.

25. Investing in Commodity Futures

2. The relationship between commodities and capital is characterized by:

• Higher prices for commodities, which increase both inflation and interest rates, which

negatively affect stocks and bonds.

• Prices of commodities that are affected by short-term expectations and stocks and

bonds reflecting long-term expectations.

• A tradeoff between the cost of capital and the cost of raw materials.

• Commodities that are subject to positive event risk because price shocks are usually

in the form of reduction in supply, which result in :

o Positively skewed return distribution for commodities.

o Positive returns for commodities and negative returns for stocks and bonds.

o A reduction in the supply of the commodity to the market.

3. Empirical findings indicate that commodities are an effective hedge for unexpected inflation

and can provide diversification benefits to portfolios of stocks, bonds, and T-bills. Other

empirical findings show that commodities are more effective at hedging inflation than real

estate or the stocks of commodity producers.

4. The characteristics of a desirable commodity index include long positions only (i.e., investable)

and do not include leverage (i.e., no margin purchases) or financial futures.

• Unlike the commodity futures contracts, commodity indices are adjusted so that the

impact of leverage is removed. An unleveraged index is assumed to be fully

collateralized by the purchase of an equal dollar amount of U.S. T-bills equal to the

face value of futures contracts.

• Economic exposure is the potential for gains and losses to the purchaser of a

commodity futures contract as the price of the underlying commodity changes.

• The commodity indices represent unleveraged passive exposure to long positions in

commodity futures, whereas managed futures accounts are levered, actively

managed portfolios of commodity and financial futures.

• The sources of commodity index returns include the price changes, the collateral

yield, and the roll yield.

• Collateral yield is the interest earned on U.S. T-bills used to collateralize the

commodity futures index.

• Roll yield is the holding period return that results from the commodity futures term

structure.

• As the time to maturity is reduced, the futures price must converge toward the spot

price; therefore, the roll yield becomes larger as time to maturity decreases (i.e., yield

is more positive for backwardated markets and more negative for contango markets)

5. The GSCI is a long-only, tradable index for physical commodity futures contracts.

• The GSCI is production-weighted, using exogenous economic data to reflect the

importance of each component to the global economy.

• The five groups of real assets in the GSCI are precious metals, industrial metals,

livestock, agriculture, and energy. Energy makes up over 70% of the index.

• The distribution of returns for the GSCI is described as being positively skewed and

leptokurtic, therefore indicating that the exposure to event risk is beneficial to GSCI

returns.

6. The DJ-AIGCI is a long-only, diversified index of physical commodities.

• The commodities in the DJ-AIGCI are from the following groups: energy, precious

metals, industrial metals, grains, livestock, and soft commodities (which include

coffee, cotton, and sugar).

• The DJ-AIGCI is weighted primarily by the trading volume of the future’s contracts and

secondarily on production. The index also requires that no group comprise more than

the 33% of the index and that each commodity must represent at least 2% of the

index. Although the index weights are rebalanced each January, the commodity

weights in the index vary based on each commodity’s value. Thus, the index is

momentum-based because of its reliance on the liquidity, as indicated by trading

volume.

• The distribution of returns for the DJ-AIGCI is described as being positively skewed

and slightly leptokurtic, therefore indicating that the exposure to event risk is beneficial

to DJ-AIGCI returns.

7. The CRB Index is a naïve index that equally weights each of the 19 physical commodities that

comprise the index.

8. The MLMI allows for both long and short positions in physical commodity, financial, and

currency futures.

• The MLMI invests in 22 contracts, including commodities, financials, and currencies.

• The MLMI is an equally weighted index based on pricing trends over the prior 12

months.

• The distribution of returns for the MLMI is described as being negatively skewed and

leptokurtic, therefore indicating that the exposure to event risk is not beneficial to

MLMI returns.

26. Commodity Futures in a Portfolio Context

1. The positive correlation between commodity futures indices and inflation provides a hedge

against the declining values of stocks and bonds that occur during periods of high inflation.

2. Commodities are a better inflationary hedge tool than TIPS because commodities increase in

value during periods of inflation, while TIPS only preserve the purchasing power of the bond.

Therefore, during periods of high inflation, increases in the value of commodities can offset the

decline in the value of stocks and bonds.

3. Because of their negative correlation with inflation, international stocks do not provide inflation

protection for U.S. stocks or U.S. bonds.

4. Although commodity futures indices are volatile, each of the four commodity indices has low or

negative correlation with the S&P 500, U.S. Treasury bonds, and foreign stocks. Therefore,

commodity futures should be considered in the construction of a diversified portfolio.

5. The efficient frontier is a graph of the best risk-return combinations of risky assets. Each point

on the efficient frontier represents the combination of assets that produces the highest level of

return for a given level of risk or the lowest amount of risk for a given return.

6. Adding a commodity futures index to a portfolio will produce a more efficient portfolio. That is,

for each level of risk, the portfolio’s returns are higher, and for each level of return, the

portfolio’s risk is lower.

7. Adding commodity indices to a portfolio of stocks and bonds produces a more efficient set of

portfolios. Risk-averse investors will benefit most from the inclusion of commodity futures in

their portfolios.

8. Empirical studies have reported an increased correlation among equity markets from different

countries during periods of economic downturns. Higher levels of correlation reduce the

diversification benefits of a portfolio that includes equities from many different countries.

9. An analysis of historical returns indicates that including any of the four commodity futures

indices as a portion of a portfolio of U.S. stocks and U.S. bonds will improve the downside risk

protection of the portfolio.

27. Managed Futures

1. A commodity pool is a collection of investors who combine their funds to invest in the

commodity futures market.

2. Public commodity pools are available to the general public and are required to register with

the SEC. Public commodity pools have low initial minimum levels of investment and are

considered liquid investments.

3. Private commodity pools avoid SEC registration requirements by selling to institutional

investors and to high net worth individuals. Private commodity pools have more flexibility in

implementing investment strategies and have lower brokerage commissions.

4. CPOs hire professional money managers called CTAs to manage the funds in the commodity

pool.

5. The CBOT was formed in 1848 and began trading futures on corn and other agricultural

products in 1850. The CME was formed shortly after the CBOT and traded futures contracts

on livestock products. When currencies became more volatile in the 1970s currency futures

were introduced. As futures contracts on debt instruments and equity indices became popular,

additional futures trading strategies were developed by those in the managed futures industry.

6. The standard fees charged by CPOs and CTAs are 2% management fee and 20% incentive

fee, referred to as 2 and 20.

7. The CEA of 1974:

• Set standards for financial reporting, offering disclosure, and record keeping.

• Requires that the CPOs and CTAs register with the CFTC and the NFA.

• Established the role of the NFA to self-regulate the managed futures industry.

8. Empirical research on managed futures reports that:

• Futures managed by CTAs are beneficial to investors.

• Selecting CTAs based on prior performance will be about the same as a naïve

strategy because of the lack of performance consistency for managed futures.

• There are the following empirical results of public versus private commodities:

o Public commodity pools are not attractive investments and are not an

attractive hedge for inflation.

o Private commodity pools have high Sharpe ratios and provide value to a

portfolio of stocks and bonds.

9. A highly skilled CTA will have a distribution of returns that is positively skewed, indicating the

CTA was able to add value.

10. Although the Barclay Agricultural CTA Index is positively skewed, the mean return is lower

than the MLMI; therefore, the performance results are mixed.

11. Although the Barclay Currency CTA Index is positively skewed and the mean return is higher

than the MLMI, the higher value for kurtosis indicates that the results are influenced by

outliers.

12. Although the Barclay Financials and Metals CTA Index is positively skewed, the mean return

is negative. Therefore, the CTA does not add value to the investor.

13. The Barclay Diversified Trader Index is positively skewed and has a higher mean return than

the MLMI. Therefore, the index may add value to the investor.

14. Including managed futures in a portfolio of U.S. stocks and bonds will not improve

diversification benefits, but will improve the downside risk protection. The addition of a 10%

weight in the MLMI to the portfolio is reported to have more downside protection than any of

the Barclay’s indices.

Index Characteristics

Index Characteristics Contracts Type Rebalancing Skewness Kurtosis

24 physical

commodities

Only long contracts across:

Production-value Weights set one time

positions in precious metals,

weighted using per year in January; no Positive

GSCI contracts with livestock, Leptokurtic

exogenous minimum or maximum (largest)

the least time to agriculture, and

economic data weight

maturity energy, with energy

making up over

70% of the index

19 contracts from

the following

groups: energy,

Constant rebalancing:

precious metals,

Only long in Liquidity data- maximum weight of 33%

industrial metals, Positive Slightly

DJ-AIGCI physical primarily trading per group and a

grains, livestock, (smallest) leptokurtic

contracts volume minimum of 2% for each

and soft

commodity

commodities (which

include coffee,

cotton, and sugar)

19 physical

CRB Naive index Equally weighted Rebalanced monthly Positive Platykurtic

commodities

Can be long

22 contracs

and short in Equally weighted,

including

physical based on moving

MLMI commodities, Rebalanced monthly Negative Leptokurtic

commodities average of prior

financials, and

and financial 12 months

currencies

contracts

28. Introduction to Private Equity

1. The four strategies relating to private equity are venture capital, leveraged buyouts (LBOs),

mezzanine financing, and distressed debt investing.

2. Venture capital involves attracting equity investments in start-up ventures that are unable to

attract capital from traditional bank loans.

3. Important developments in the history of venture capital include the first venture capital fund

(American Research and Development – formed in 1946), Congress’ establishment of Small

Business Investment Companies, the limited partnership concept, allowance of pension

investing in venture capital, and promotion of venture investing by investment advisers.

4. Venture capital returns should earn between a 5% and 7% return over and above the overall

market, when viewed over an entire business cycle.

5. Venture capitalists generally take two rules in the industry: raising capital and investing in

firms. They may also assist in active management of the firm, provide expert advice, and

provide customers.

6. Venture capitalists’ main areas of focus are:

• Business plans.

• Intellectual property rights.

• Prior operating history.

• Start-up management team.

• Legal and regulatory issues.

• Exit plan.

7. Over the past 15 years, there have been three new sources of venture capital funding:

endowments, intermediaries, and individuals.

8. The various venture capital investment vehicles include:

• Limited partnerships.

• Limited liability companies.

• Corporate venture capital funds.

• Venture capital fund of funds.

9. The stages of venture capital financing include:

• Seed financing.

• Venture capital “feeder fund”.

• Mid- or late-stage rounds.

10. An LBO is a way to take a public company private, usually financed by the firm’s assets, cash

flows, debt financing, and/or bank loans. A management buyout (MBO) is an LBO where the

investors are the current management team. Merchant banking is the purchase of non-

financial firms by financial institutions.

11. EBITDA = earnings before interest and taxes + depreciation and amortization.

12. The following are important developments in the history of LBOs:

• 1976 – Kohlberg Kravis Roberts & Co. (KKR) is created

• 1980s – Growth in junk bond popularity, KKR buys RJR Nabisco, Michael Milken

makes his name

• 1990s – U.S. recession, Russian bond default, decline in LBO market

• 2001 – Development of exchange-traded private equity

13. LBO funds are financed through three primary sources:

• Senior debt – 40% to 60% of transaction; provided by banks, finance companies,

insurance companies; expected returns of 400 to 500 bps over LIBOR; payback of

two to three times EBITDA over four to six years.

• Mezzanine debt – 20% to 30% of transaction; provided by mezzanine debt funds,

institutional investors, investment banks; expected total returns of 17% to 20%;

payback of one to two times EBITDA over five to seven years; equity kicker enhances

returns.

• Equity – 20% to 40% of transaction; provided by LBO firm, management, equity

component of mezzanine debt; expected total returns of 20% to 40% over five to

seven years.

14. The compound annual return on an LBO is computed as follows:

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"#$% &'()*+, &#-.*)

• LBOs that improve operating efficiency.

• Unlocking an entrepreneurial mindset.

• Overstuffed corporation.

• Buy and build strategies.

• LBO turnaround strategies.

16. There are several ways in which an LBO firm earns fees:

• Management fees.

• Profit sharing fees.

• Privatization fees.

• Break-up fees.

• Divestiture fees.

17. LBO funds, venture capital funds, and hedge funds often are structured as limited partnerships

with the fund manager as general partner and sole decision maker. LBO funds tend to have

higher fees, however.

18. The performance of an LBO fund should be compared to other funds with the same vintage

year since they are likely to be in a comparable stage of the LBO life cycle.

19. Corporate governance is a process in which manages of a firm align interests with equity

holders.

20. LBOs are less risky than venture capital because the LBO target company has established

products, established management, and a greater likelihood of using an IPO exit strategy.

LBOs are highly leveraged and are therefore highly risky, but highly profitable investments.

21. To have a successful LBO, it is very important that the management of the firm and the LBO

firm have closely aligned interests and a solid business plan.

22. There are three general purposes of mezzanine financing:

• Mezzanine financing to bridge a gap in time (could be associated with a specific

project).

• Mezzanine financing to bridge a gap in capital structure.

• Mezzanine financing to bridge a gap in an LBO.

23. There are key differences between mezzanine funds and venture capital funds:

• Return expectations:

o Mezzanine funds: 15%-20% (or low twenties).

o LBO funds: mid-to-high 20%.

o Venture capital funds: > 30%.

• Mezzanine financing carries a high interest rate.

• Venture capital funds and mezzanine funds are staffed with personnel with different

expertise.

24. The advantages of mezzanine debt to the investor include high equity-like returns, priority of

payment, schedule of repayment, board representation, and restrictions on the borrower.

25. There are also advantages of mezzanine debt to the borrower:

• Flexibility.

• Semi-equity.

• Lengthening of maturity.

• No collateral has to be pledged with mezzanine debt.

• Less equity dilution.

• Cheaper than common equity.

26. Mezzanine financing generally includes restrictions on senior creditors including subordination

(blanket or springing), acceleration, drawdown, amendment restrictions, assignment,

insurance proceeds commitments, and takeout provisions.

27. There are several ways a distressed debt investor can gain control of a firm through a

bankruptcy:

• Using distressed debt to recycle private equity.

• Distressed buyout.

• Using distressed debt for a takeover.

28. Factors that contributed to the growth in the distressed debt market in the 1990s include: an

expansion of the number and types of loans being resold, bank risk management techniques

that call for the sale of sub-performing loan assets, rapidly increasing debt levels, and an

increase in start-ups and subsequent failures.

29. Distressed debt investors (vultures) purchase the debt of financially troubled companies for a

cheap price, initiate a turnaround, and either sell the debt after it recovers its market value or

take an equity stake in the company.

30. Chapter 11 bankruptcy can be a long, complicated process and includes the following steps:

• Debtor files for protection under chapter 11 of the U.S. Bankruptcy Code.

• Bankruptcy court freezes default notices from lenders.

• Firm seeks approval of pre-packaged reorganization plan if it exists; if not, firm must

submit plan within 120 days.

• After filing plan, firm has 60 days to gain acceptance by creditors.

• ½ the number and 2/3 value of each claimant class must accept plan to seek court

approval.

• If 120- and 60-day periods pass without a plan any party of interest may submit a plan

which, if accepted by the firm, is submitted for court approval.

• If the firm rejects the alternative plan it must submit a new plan and seek approval, or,

alternatively, the court can force a cramdown.

31. There are two main risks of distressed debt investing: business risk and lack of liquidity.

32. A distressed debt arbitrage is conducted by purchasing undervalued distressed debt and

shorting the underlying firm’s stock. The arbitrager waits for the firm’s prospects to improve,

increasing the debt and equity value. Generally, the large bond interest payments and value

appreciation more than offset any losses.

29. Performance Measurement for Private Equity

1. Results from investing in venture capital (VC), LBOs, mezzanine debt, and distressed debt

over the period 1991 to 2005 include the following:

• Returns to VC exceeded that of the S&P 500 and of the other three private equity

classes. The result is as expected as VC firms take on significant business risk.

Returns were asymmetrical, with large positive skewness and kurtosis.

• LBO returns closely tracked that of the S&P 500 up until 2002, after that, LBOs

earned a positive excess return. The return distribution was nearly symmetrical, with

slightly negative skewness and kurtosis.

• The performance of mezzanine debt was mixed, with performance in line with the

S&P 500 in the early 1990s, but underperformance after. Some underperformance is

expected because of the downside protection of the debt component. The return

distribution for mezzanine debt is less negatively skewed than that for high-yield

bonds, reflecting the downside protection of the debt feature and the ability to

participate in equity appreciation.

• Over the period 1991 to 1997, distressed debt earned a premium over the S&P 500,

but underperformed thereafter. Significant events include Russian debt defaults and

the collapse of LTCM. The returns distribution is slightly negative skewed and the

kurtosis is large and positive.

2. Over the 1991 to 2005 period, LBOs and mezzanine debt have the highest Sharpe ratio at

0.40. VC has the next higher at 0.27, and distressed debt is last with a Sharpe ratio of 0.12.

3. Adding each private equity class (VC, LBOs, mezzanine debt, and distressed debt)

individually shifts the efficient frontier up and to the left, indicating the existence of

diversification benefits. The shift was greater for venture capital and the least for distressed

debt.

4. Information asymmetry and illiquidity create a disconnect between the value of private equity

investments and the value of the overall market. This disconnect renders the comparison of

private equity returns to an objective benchmark ambiguous. Part of the problem is the

structure of the private equity market.

• Investors use intermediaries to invest their capital since they lack the time or expertise

to act as individuals. This creates information asymmetry in favor of the intermediary.

• Intermediaries pool the assets of investors to purchase closely held, illiquid securities

over which they have investment and valuation discretion. Intermediaries have

incentive, through performance bonuses, to withhold information and manage the

pricing of the portfolio.

• Issuers are young firms with little publicly known information. This results in

information asymmetry whereby the issuer has better information than intermediaries

or investors. Securities are thinly traded if at all.

• Information processors exist to reduce information asymmetries. Information

processors assess the presence of stale or managed pricing in intermediaries’

reported performance.

5. Stale pricing occurs when the book value of a private equity investment does not reflect the

current market value.

• Conservative intermediaries waiting for objective market events before repricing may

carry stale prices on their books.

• Stale prices lag the general public market resulting in low correlation and volatility

estimates.

6. Managed pricing occurs when intermediaries quickly mark up the value of the private equity

portfolio after a gain and slowly mark down the portfolio after a loss.

• Performance incentives and the need to raise additional capital from investors often

give rise to managed pricing.

• Managed prices lag the general public market and, like stale prices, create problems

using the CAPM model.

7. Gompers and Lerner recommend overcoming stale or managed pricing by periodically

(quarterly) marking private equity portfolios to market. They tested their theory using the

CAPM regression analysis and found marking to market reduced the excess return (:)

estimate but increased the explanatory power of the model.

8. Beta estimates (market risk exposure) for private equity investments can be determined using

the following regression model:

RMt in the preceding equation represents the market return. The NASDAQ, Russell 1000,

Russell 2000, S&P 500, Salomon Brothers Cash Pay High Yield Index, and Salomon Brothers

Convertible Bond Index were used as market proxies.

9. Excess risk-adjusted return is the return earned by the manager in excess of the risk-free rate,

the market return, and any return attributable to random events. The one-period regression

model can be rearranged to isolate the term :, which represents excess risk-adjusted return

(also known as manager skill) without adjusting for stale or managed prices.

10. We can adjust the excess risk-adjusted return estimate for stale or managed pricing by using

a regression model with lagged excess market return (i.e., lagged market return minus lagged

risk-free rate). The term in the lagged multiple-period model has the same interpretation as the

one-period :.

11. Excess risk-adjusted return estimates from the single-period and multiple-period (using three

lagged quarters of market returns) regression models are directly comparable. In summary,

alphas for each private equity asset class declined from the single regression to the multiple

regression case. Based on the multiple regression results, it appears that LBO, mezzanine

debt, and distressed debt managers provide some positive alpha based on skill and that VC

alphas are due more to random events.

2

12. R measures the variation of the dependent variable (private equity returns) explained by the

2

independent variable(s) (market returns). R for the multiple-period regressions were higher

than those for single-period regressions indicating the presence of stale and managed pricing.

13. To determine whether non-synchronous pricing is the result of stale or managed pricing,

dummy variables are introduced into the multiple-period regression model.

• Regression 1 (up market): D equals zero if the market is down and one if the market is

up.

• Regression 2 (down market): D equals one if the market is down and zero if the

market is up.

• If the beta estimates from the two regressions are asymmetric, managed pricing

exists.

• If up-market betas are greater than down-market betas, private equity managers are

slow to mark portfolios up and follow the principal of conservatism.

• I down-market betas are greater than up-market betas, private equity managers are

quick to mark portfolios up to enhance their performance.

14. Regression results to test for managed pricing reveal that each private equity asset class

exhibits evidence of managed pricing, primarily based on asymmetric lagged beta results.

30. Trends in Private Equity

1. The private equity market has evolved from single sourced deals to an auction market where

multiple private equity firms compete for deals in a bidding process. The development of an

auction market reflects:

• A more efficient and mature market where more capital leads to more competition,

which in turn leads to lower returns for investors.

• The potential for less efficiencies as private equity firms have less time to conduct due

diligence and get to know the management of the firms they are doing deals with.

2. Club deals occur when multiple firms work together on a single deal to share costs, present a

business plan, and contribute capital.

3. Advantages of club deals include the following:

• Limiting the auction process to allow a target to be acquired for a more attractive

price.

• Bringing in diverse knowledge or skills to potentially enhance the value of a target

company.

• Diversifying risk.

4. Disadvantages of club deals include the following:

• Lack of opportunity in the marketplace.

• Lack of defined leadership for the business plan of the private equity deal.

• Allowing weak firms without independent deal flow to attach themselves to other

companies’ deals.

5. The secondary market for private equity exists at both the private equity firm and individual

investor level.

6. Advantages of the development of a secondary market include the following:

• Providing liquidity to investors.

• Providing a more effective way to diversify private equity investments.

• Earning positive returns from private equity investments more quickly.

• Creating a way to establish a relationship with general partners in order to gain

access to future deals.

7. Disadvantages of the development of a secondary market include the following:

• Secondary buyouts may reflect too much money chasing too few deals.

• Incentive fees reduce value for investors.

• Increased efficiency and competition reduces return for investors.

8. BDCs are a unique type of closed-end mutual fund that was created to promote investments in

small private businesses. Factors that allow BDCs to compete with traditional private equity

investments include the following:

• Providing significant fee income for the private equity firm.

• Providing investors the opportunity to earn returns that exceed the returns for

traditional bonds.

• Giving investors a liquid market since shares of the BDC trade on a public exchange.

9. The deal terms of hedge funds have a number of advantages over private equity firms:

• Hedge funds can receive incentive fees at any time, while private equity funds only

receive incentive fees after returning capital to investors.

• Hedge fund incentive fees are based on changes in NAV, while private equity fund

incentive fees are based on realized profit.

• Hedge fund incentive fees are collected on a regular basis (e.g., quarterly).

• A hedged fund does not need to recoup management fees before paying incentive

fees, while a private equity fund does.

• Hedge funds typically do not have provisions for the clawback of management or

incentive fees, while private equity funds do.

• Hedge funds typically target a return in excess of cash (i.e., LIBOR + 5%), while

private equity firms try to achieve returns greater than 20%. Having a lower target

return allows hedge funds to be more aggressive in the bidding process.

10. Leveraged loans refer to loans made to borrowers who do not carry an investment grade

credit rating.

11. The rapid growth in the market for leveraged loans has been influenced by both private equity

firms and collateralized loan obligation funds.

• Private equity firms have a great deal of experience dealing with banks and other

fixed income investors to finance their buyouts, which provides a natural entry into the

leveraged loan market.

• Collateralized loan obligation funds give investors a means to access the market for

leveraged loans, which is characterized by offering high yields, relatively stable

returns, seniority in the hierarchy of credit claims in the event of default, and low

correlation with traditional asset classes.

12. PIPEs involve the issuance of private equity, convertible notes, or convertible preferred stock

at a discount by a publicly traded company. PIPE securities cannot be sold by the investor

until they are registered with the SEC. The primary reasons for issuing discounted equity are

the following:

• Newly public companies have a small float and do not wish to dilute shareholders.

• Private securities avoid the intense scrutiny of Wall Street analysts.

• The company can control who receives the securities.

• PIPE transaction costs are much lower than those for public securities.

13. Toxic PIPEs involve the issuance of floating convertibles, reset convertibles, reset common

equity, or reset convertible preferred that have a floating conversion rate that increases as the

stock price declines and can cause a death spiral.

14. Toxic PIPEs and death spirals can be prevented through the use of price floor provisions that

limit the increase in the floating conversion ratio.

Private Equity Return Distribution

Standard

Average Skewness Kurtosis

Deviation

Venture Capital 4.13% 11.00% 2.76 14.890

Leveraged Buyouts 3.49% 5.66% -0.03 -0.076

Private Equity

Mezzanine debt 3.00% 4.50% -0.32 1.620

Distressed debt 1.11% 6.05% -0.63 7.050

S&P 500 1.01% 4.40% -0.63 0.580

Benchmarks

SB High Yield 0.75% 2.05% -0.81 4.160

31. Introduction to Credit Derivatives

• Default risk is the risk that the issuer of a bond will not meet required interest or

principal payments.

• Downgrade risk is the possibility that the credit rating of an asset/issuer is

downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO).

• Credit spread risk is the risk of increase in the spread between the yield of the risky

asset and the yield of a risk-free benchmark security.

2. There are two methods for measuring credit risk:

• Credit ratings are given by NRSROs as a measure of an issuer’s credit risk.

• Credit risk premiums refer to the difference between the yield on a risky asset and a

comparable risk-free Treasury security and reflect the compensation an investor

receives for bearing credit risk.

3. There are three traditional methods for managing credit risk:

• Underwriting standards refer to a lender’s process of analyzing a borrower’s financial

position and the industry a borrower operates in before deciding how much money to

lend.

• Diversification refers to making loans across multiple industries to reduce the lender’s

risk that every loan in a portfolio will default at the same time.

• Asset sales are the sale of loans to outside parties in order to remove the loan from

the lender’s balance sheet.

4. Credit risky investments have a low correlation with the S&P 500 and U.S. Treasury securities,

and therefore offer an opportunity to diversify a portfolio consisting of traditional asset classes.

5. High yield debt refers to bonds that have a large credit risk premium compared to a

comparable U.S. Treasury bond and typically do not carry investment grade ratings from

NRSROs.

6. The return distribution for high yield debt has a high value of leptokurtosis and is negatively

skewed, reflecting significant downside risk as a result of defaults, downgrades, and widening

of credit spreads.

7. The leveraged bank loan market is made up of loans to companies with a credit rating below

investment grade, or loans that are priced at a 150 basis points or greater spread over LIBOR.

8. Leveraged bank loans come in the form of revolvers or term loans.

• Revolvers are lines of credit (with fixed amortization schedules that are) typically used

to back commercial paper programs of financially stable companies.

• Term loans have fully funded commitments with fixed amortization schedules. They

are typically used by companies that have lower credit ratings.

9. There are five key factors that explain the growth of the leveraged bank loan market:

• Convergence of the bank loan and high yield debt markets.

• Increasing role of insurance companies as a result of deregulation.

• Acceptance of bank loans by institutional investors.

• Securitization through CLOs.

• Providing a means for banks to more effectively manage their risk capital.

10. Bank loans have the most consistent returns of the four credit risky asset classes discussed in

this topic review with less negative skewness and less excess kurtosis than the return

distributions for other credit risky assets.

11. Out of the four categories of credit risky investments, emerging markets debt has the most

skewness and the most excess kurtosis, implying the greatest downside risk. However, most

of the downside risk can be traced to emerging markets crises in 1997 and 1998.

12. Distressed debt is debt that has been impaired by default, bankruptcy, or an extremely low

credit rating with a high probability of default.

13. Distressed debt has the most dispersion of any of the risky debt categories we have

discussed, and considerable exposure to event risk.

14. Credit derivatives provide four key advantages to investors:

• Isolation of credit risk.

• Transfer of credit risk.

• Provide liquidity in times of market stress.

• Transparency in credit risk pricing.

15. Both credit outs and credit calls protect against declines in market values as a result of credit

quality deterioration. The key difference is that credit puts provide a cash payment based on

the value of the underlying bond, while credit call options provide cash payments in the form of

additional coupon income.

16. Credit-linked notes (CLNs) offer investors higher coupon interest in exchange for bearing a

portion of the credit risk associated with the note.

17. The buyer of a total return swap receives the total return of a reference asset in exchange for

LIBOR +/- spread, and assumes all credit risk exposure associated with the asset. The seller

of the total return swap retains ownership, but since cash flows are passed to the buyer, the

seller receives a net cash flow of LIBOR +/- spread.

18. A credit default swap (CDS) is similar to an insurance contract and only makes a payment if a

credit event occurs. In the case of a total return swap (TRS), the swap buyer receives the total

return of the reference asset regardless of whether a credit event occurs.

19. Terms negotiated between the CDS buyer and seller include:

• CDS spread.

• Contract size and maturity.

• Payment trigger events.

• Method of settlement.

• Choice of assets to deliver.

20. The ISDA has identified six specific types of payment trigger events:

• Bankruptcy.

• Failure to pay.

• Restructuring.

• Obligation acceleration.

• Obligation default (technical default).

• Repudiation/moratorium by a sovereign government.

21. Four types of risk associated with credit derivatives are:

• Operational risk.

• Counterparty risk.

• Liquidity risk.

• Pricing/model risk.

32. Introduction to Collateralized Debt Obligations

1. The key to the growth of the CDO market is that CDOs give investors, banks, and brokerage

firms the ability to repackage and transfer credit risk. Specifically, the growth of the CDO

markets can be explained by four factors:

• CDOs give investors access to a diversified pool of risky credit assets.

• Credit tranching allows investors to target specific risk exposures.

• CDOs give banks an effective way to manage credit risk.

• Fees earned by asset managers and brokerage firms provide an incentive to

encourage the use of CDOs.

2. The primary difference between balance sheet CDOs and arbitrage CDOs is the motivation of

the entity issuing the security:

• Balance sheet CDOs are issued primarily by banks or insurance companies as a

means to manage the assets on their balance sheet and the associated credit risk

exposure of those assets.

• Arbitrage CDOs are issued primarily by money managers who are seeking to earn an

arbitrage profit between the return on the collateral and the funding costs of the CDO.

3. A special purpose vehicle (SPV)is used to hold the assets in a CDO structure and is legally

separate from the CDO sponsor, meaning that it is not exposed to the parent’s credit risk

(bankruptcy remote).

4. Waterfall refers to the method where cash flows from the CDO collateral flow to the various

tranches in a CDO structure. Collateral cash flows flow in order of seniority where cash is first

used to meet obligations of the most senior tranche and does not flow to the subsequent

tranche until the senior tranche’s obligations are met in full.

5. In a cash funded balance sheet CDO, a bank removes part of its loan portfolio from its

balance sheet by selling and transferring the assets to an SPV, where the SPV uses the

assets’ cash flows to make payments to the CDO tranches.

6. A synthetic CDO uses credit derivatives to gain exposure to the assets collateralizing the

CDO.

7. There are four key differences between a cash funded and a synthetic CDO.

• Transfer of ownership.

• Use of proceeds from the sale of CDO securities to investors.

• Use of leverage.

• Difficulty in transferring assets.

8. The sponsoring bank and investors can both benefit from the use of a synthetic balance sheet

CDO:

• The bank reduces risk and frees regulatory capital by transferring risk exposure from

loans to the CDO trust. It also locks in a return equal to the difference between the

bank’s cost of funds and the rate paid by the total return swap.

• Investors can receive higher returns on investment grade securities through the use of

leverage in the CDO structure.

9. Synthetic CDOs using credit default swaps are often called correlations products because the

CDS exposure is tied to the default of more than one bank loan. The higher the default

correlation of the referred loans, the higher the risk of the CDS, and in turn the CDO

securities.

10. Ways banks benefit from CLOs include the following:

• Reducing risk-based regulatory capital requirements (most important).

• Increasing capacity for additional loans.

• Improving profitability measures.

• Reducing credit concentrations in particular industries.

• Maintaining positive customer relations.

• Competitive positioning with investors.

11. Cash flow arbitrage CDOs depend solely on the cash flows generated from the collateral pool

to repay the securities sold by the CDO, while market value arbitrage CDOs actively sell

assets in order to make payments to CDO investors.

12. Synthetic arbitrage CDOs are used by investment management firms who try to profit from

receiving a high yield on collateral assets and paying a lower yield on the CDO trust securities,

and use credit derivatives to transfer the risk exposure of a portfolio of assets without any

change in the legal ownership of the assets.

13. A money management firm profits from the spread between the CDO collateral income and

the interest paid to CDO note holders. The money manager may also earn asset management

or transaction fees from this spread income.

14. The three phases of a CDO life cycle consist of the following:

• Ramp up phase, where the CDO manager builds the collateral portfolio.

• Revolving period, where the CDO manager reinvests cash flows and manages the

portfolio.

• Amortization phase, where principal payments are made to CDO security holders.

15. New developments in CDOs use different forms of collateral in a CDO structure to create

exposure to different asset classes and cash flow patterns:

• Distressed debt CDOs use distressed debt as the primary collateral component and

can provide a series of tranches that have an investment grade credit rating even

though the underlying collateral has a speculative grade.

• Hedge fund CDOs are backed by hedge funds of various strategies.

• Collateralized commodity CDOs are backed by derivatives called Commodities

Trigger Swaps (CTS), where payments between counterparties are based on a

commodity index hitting a certain price level.

• Private equity CDOs are collateralized by investments in private equity funds and give

investors the ability to access the private equity asset class through investment grade

securities.

• Single tranche CDOs work like a normal synthetic CDO by using a CDS to transfer

risk exposure. However, it is only a specific portion of the collateral portfolio’s risk that

is transferred to investors.

• Unfunded CDOs allow investors to gain credit exposure without paying cash for the

security. The investor effectively takes a position in a CDS where the investor

receives payments as a credit protection seller and must pay the CDO issuer if the

underlying CDO collateral suffers credit losses.

2

• A CDO squared (CDO ) is a CDO that invests In other CDOs as part of its collateral

pool and is particularly susceptible to model risk as a result of pricing models relying

on two sets of assumptions.

16. Key risks associated with CDOs include:

• Default risk of the collateral backing the CDO (most important risk).

• Downgrade risk.

• CDO default rates.

• Differences in interest payment receipt periodicity.

• Differences in interest payment dates.

• Basis risk.

• Compression of credit spreads.

• Changes in the sharpe of the yield curve.

17. The conflict between maintaining a high weighted average rating factor (WARF) and

maintaining a high weighted average spread (WAS) over LIBOR creates a challenge for the

CDO manager who must balance the goal of having a high credit quality with achieving a high

rate of income.

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