Lecture 3 – Active Investment II

AFIN3052 APPLIED PORTFOLIO MANAGEMENT

Fundamentals: Performance Measurement

This class

2
Transaction Costs and Market Liquidity Risk
• Transaction costs:
― Commissions and other direct costs
― Bid–ask spread
 bid price: is the price at which you can sell shares
 ask price is the price at which you can buy shares
― Market impact costs
• Securities with high transaction costs are said to be illiquid
• Market liquidity risk: the risk of episodic spikes in transaction costs

3
Transaction Costs: Understanding a Limit Order Book

• Main order types:

― Limit orders

― Market orders
Market Liquidity: Trading Implications

• Which trading rule is the best

• Whether or not a strategy is profitable

• Which securities to trade

• How large to scale the trade (capacity)

Optimal Trading in Light of Transaction Costs
• Increasing transaction costs (as a function of trade size): Market impact.
― In liquid electronic markets with very small minimum tick size
― E.g., today’s equity and futures markets in the U.S.
― Main source of transaction costs for large traders: market impact
― Optimal trading strategy: split up a trade into many small orders and trade these small orders
patiently over time
• Decreasing transaction costs
― In over the counter (OTC) markets, you often need to call a dealer on the phone to trade
― Optimal trading strategy: trade in chunks that are worth the dealer’s time
― To execute the trade, hedge funds often call multiple dealers to get competitive bids
• Constant transaction costs: Bid–ask spreads.
― (Also called proportional transaction costs, since total transactions costs are proportional to trade
size when average costs are constant.)
― Optimal trading strategy: Only trade once in a while to save on trading costs, staying within a
band of the desired position
Optimal Trading with Increasing Average Trading Costs
16
14
12
10
8
6
4
2
0
-2
-4
Optimal position w/ quadratic TC Optimal position w/o TC
Optimal Trading with Constant Average Trading Costs

16
14
12
10
8
6
4
2
0
-2
-4
-6
Optimal position w/ proportional TC Optimal position w/o TC
upper bound lower bound
Optimal Trading with Decreasing Average Trading
Costs (Fixed $ Costs)
16
14
12
10
8
6
4
2
0
-2
-4
-6
Optimal position w/ fixed $TC Optimal position w/o TC upper bound lower bound
Measuring Transaction Costs
• Dollar transaction costs versus pre-trade price, for buys:
TC$,effective = Pexecution – Pbefore
• For sell orders:
TC$,effective = – ( Pexecution – Pbefore )
• Percentage transaction costs:
TC = TC$ / Pbefore
• Works for
― commissions
― bid–ask spread, and
― market impact costs
• If you trade over an extensive time period
― TC is measured with substantial noise

10
Measuring Transaction Costs
• Another measure of transaction costs is the temporary price impact as captured by the subsequent
price reversal. For buys:
TC$,realized = Pexecution – Plater
• Another way to measure transaction costs is to compare the execution price to the so-called volume-
weighted average price (VWAP). For buys, this means
TC$,VWAP = Pexecution – PVWAP
Example
• Suppose you are the only buyer all day, and push the price up a lot
• What will be your measured
― TC$,effective
― TC$,realized
― TC$,VWAP
?
Estimating Expected Transaction Costs
• Suppose that you have measured TCi during each of your trade executions i
• Simple estimate of expected transaction costs:
1
�
𝐸𝐸(𝑇𝑇𝑇𝑇) = ∑𝑖𝑖 𝑇𝑇𝐶𝐶𝑖𝑖
𝐼𝐼
• More generally, HFs estimate the expected transaction costs as a function of
― Trade size,
― Security or security characteristics, and
― Market conditions
• Estimates
from ITG:

12
Implementation Shortfall: The Costs of Trading and Not Trading
• Paper portfolio: your desired portfolio if trading costs were zero
― Performance of paper portfolio: compute return and re-adjust the portfolio in real time
― as if you can trade any number of shares at the mid quote
• Real-life performance differs from that of the paper portfolio because:
1. In real life, you incur transaction costs
2. In real life, you change your trading pattern, possibly causing missed opportunities
• Implementation shortfall (IS) is a measure that captures both of these costs.
― It is the sum of the transaction costs (TC) and
― The cost of not trading, i.e., opportunity cost (OC) :
IS = TC + OC
• Computing implementation shortfall (Perold (1988)):
IS = performance of paper portfolio – performance of real portfolio
• The opportunity cost can be inferred, OC = IS – TC.
Using Implementation Shortfall to Improve Trading
• Tracking whether your trading ideas are being successfully implemented:
― A hedge fund is not interested in making money in principle, but in practice
― A large shortfall drives a wedge between the two
• Studying your performance and IS can help focus your efforts on:
― improving your trading implementation or
― the strategy’s alpha signals.
― How can you use IS and paper-portfolio returns to determine this?
• How do you reduce your shortfall?
― By trading faster and being first to the market before it moves away from you?
― Or by trading more slowly and minimizing your price impact and other trading costs?
― How do you know whether a change worked?
The Capacity of a Trading Strategy

Total dollar profit Marginal shortfall

i.e. shortfall on
last dollar invested

Paper return i.e.

E(R) before shortfall

Dollars invested
Capacity of a Hedge Fund Manager

Total dollar
profit
Total dollar
profit

Paper
return
Paper return

Marginal Marginal
shortfall shortfall

assets assets
Fundamentals: Performance Measurement

This class

17
Hedge Fund Capital
• Equity capital supplied by partners:
― Not permanent, but
― withdrawal subject to lock-up and redemption notices

• Main source of leverage: collateralized loans subject to margin requirement

― Unsecured bank loans or bonds or credit lines or rare for hedge funds
 Beware of “material adverse change” clause

18
Why Use Leverage?
• You manage $100M
• Stock X is trading at $100 per share
• You are (almost) sure that the price will soon increase to $110
• How much money can you make
― without leverage?
― with leverage?
• How much leverage can you get?
• What happens if the price actually drops to $80?

19
Definition of Leverage

• leverage = long positions / NAV

• gross leverage = (long positions + short positions) / NAV

• net leverage = (long positions – short positions) / NAV

• Limits of leverage: margin requirements

20
A Hedge Fund’s Balance Sheet
Mark to Market, Interest Rates, and Financing Spreads
• P&L = change in equity=
𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙
𝑃𝑃&𝐿𝐿 = 𝑅𝑅𝑡𝑡 × $𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 − 𝑅𝑅𝑡𝑡𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 × $𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 + 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
where

𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = 𝑟𝑟𝑡𝑡 $𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑚𝑚𝑚𝑚 + 𝑟𝑟𝑡𝑡𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 $𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑠𝑠𝑠𝑠𝑠𝑠.𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 − 𝑟𝑟𝑡𝑡𝑃𝑃𝑃𝑃 $𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑃𝑃𝑃𝑃−𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙

𝑓𝑓

• Financing spreads:
𝑓𝑓
1. Interest rate paid on margin loan greater than the money market rate (fed funds): 𝑟𝑟𝑡𝑡𝑃𝑃𝑃𝑃 > 𝑟𝑟𝑡𝑡
𝑓𝑓
2. Interest rate earned on cash collateral supporting short positions less than mm rate: 𝑟𝑟𝑡𝑡 > 𝑟𝑟𝑡𝑡𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

22
Example: P&L of Market Neutral Hedge Fund
• What happened over the year:
― NAV = $100m
― Long positions = $300m, return of 10%
― Short positions = $300m, return of 5%
― Margin posted = margin requirement = 10% per side = $60m
― Excess cash = $𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑚𝑚𝑚𝑚 = $40m, invested at the money market rate,
𝑓𝑓
𝑟𝑟𝑡𝑡 =1.00%
― Debit borrowed from PB = $𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑃𝑃𝑃𝑃−𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = $300m - $60m = $240m, at 𝑟𝑟𝑡𝑡𝑃𝑃𝑃𝑃 =
1.25%
― Cash raised from shorting = $𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑠𝑠𝑠𝑠𝑠𝑠.𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 = $300m, at 𝑟𝑟𝑡𝑡𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 0.65%
• P&L from longs and short:
$300𝑚𝑚 × 0.10 − $300𝑚𝑚 × 0.05 = $15𝑚𝑚
• P&L from financing:
$40𝑚𝑚 × 1% + $300𝑚𝑚 × 0.65% − $240𝑚𝑚 × 1.25% = −$0.65𝑚𝑚
• Total P&L: $15𝑚𝑚 − $0.65𝑚𝑚 = $14.35𝑚𝑚
• Two components of financing:
$100𝑚𝑚 × 1% − $300𝑚𝑚 × 0.35% + $240𝑚𝑚 × 0.25% = $1𝑚𝑚 − $1.65𝑚𝑚 = −$0.65𝑚𝑚
interest on net cash cost due to financing spreads
What Determines Margin Requirements?
• Funding a long position: margin requirement, m:

𝑝𝑝𝑡𝑡+1 − 𝑝𝑝𝑡𝑡
Pr − > 𝑚𝑚 = 1%
𝑝𝑝𝑡𝑡
• Funding a short position
𝑝𝑝𝑡𝑡+1 − 𝑝𝑝𝑡𝑡
Pr > 𝑚𝑚 = 1%
𝑝𝑝𝑡𝑡

24
What Determines the Limits of Leverage?

• Funding the overall portfolio

� 𝑚𝑚𝑖𝑖 × 𝑝𝑝𝑡𝑡𝑖𝑖 × position size𝑖𝑖 ≤ cash posted as margin ≤ capital

𝑖𝑖
• Violating the first inequality (the portfolio’s margin constraint):
― Margin call

25
Methods of Leverage
• Repo (repurchase agreement)
― Government bonds and other fixed income securities
• Prime brokerage (PB) of cash instruments
― Stocks
― Convertible bonds
• PB of OTC derivatives
― Swaps, etc.
• Exchange-traded derivatives (FCM, DCM)
― Futures, options, CDS

26
Funding Liquidity Risk and Gambler’s Ruin
• Gambler’s ruin:
― The risk that you end up bankrupt despite having the odds in your favor
• Funding liquidity risk:
― Risk that a hedge fund cannot fund the position throughout the life of the trade
― Risk of being forced to unwind positions as the fund hits/nears a margin constraint or as investors
pull out

• Forced liquidation very costly:

― Tends to happen when investment opportunities are particularly good
― Not at a random time: more likely during a liquidity spiral (Brunnermeier and Pedersen (2009))

27
Liquidity Spiral
Price Path During Liquidity Spiral: When Everyone
Runs for the Exit

Source: Brunnermeier and Pedersen (2005)

Implications of Liquidity Spirals
Liquidity spirals mean that
• Forced liquidation can be very costly!
• There exists a crash risk that is difficult to detect during normal trading days
• Return distributions are inherently non-normal:
― While price changes are driven by fundamental news on most days
― Price changes are driven by forced selling during liquidity spirals.
• Correlations across securities can suddenly change
― During a liquidity event, the prices of securities held by traders with funding problems start to co-
move, even if their fundamentals are unrelated
• Liquidity crisis is contagious
― losses in one market can lead to fire sales in other markets, hurting more traders and spreading
the crisis
Why Do Investors Redeem Even When Trading
Opportunities are Great?
• If they fully understood the trade, they might not pay 2+20. Trade off:
― HF explains strategy and risks: bad marketing ex ante, but good in stress scenarios
― HF sells “magic alpha”: perhaps good ex ante, but investors pull out at the worst time
• High watermarks: HF may lose traders
• They think other investors will bail out
― Predatory trading
― This leads to costs for everyone
• Other reasons?
Spillover at the Beginning of the Global Financial Crisis

Source: Pedersen (2009)

Predatory Trading
• Predatory trading: Trading that
― exploits the need of others to reduce their positions
― or in fact induces it
• How can this happen?
When you smell blood in the water, you become a shark ... when you know that one of your number is in
trouble ... you try to figure out what he owns and you start shorting those stocks — Cramer (2002, p. 182)

• Example
― Suppose that the price of a stock X is currently p0 = $100
― Price moves up/down $1 for every $1M shares bought/sold
― Outflow Capital Holdings (OUCH) needs to sell 10M shares, and trader X finds out
― What might trader X do?
― Alternatively, suppose that OUCH only needs to sell if the price reaches $99 per share. Now, what
might the other trader do?
Predatory Trading
• Predatory trading can arise in many different ways, e.g.,
• Mechanical trading rules such as stop-loss orders
• Short squeeze
• “Dr. Evil” trade
• Prime brokers know a lot about a hedge fund’s positions and funding situation and have been accused
of exploiting this information:
“If lenders know that a hedge fund needs to sell something quickly, they will sell the same asset—driving
the price down even faster. Goldman, Sachs & Co. and other counterparties to LTCM did exactly that in
1998” (Business Week, 2/26/2001).
• Many times what looks like predatory trading really reflects the fact that other traders are trying to
protect themselves, since they have similar positions and fear that they will be the next one forced to
liquidate
― Everyone is running for the exit
Stop-Loss Orders and the 1987 Crash

. . . This precipitous decline began with several “triggers,” which ignited mechanical, price-insensitive
selling by a number of institutions following portfolio insurance strategies and a small number of mutual
fund groups. The selling by these investors, and the prospect of further selling by them, encouraged a
number of aggressive trading-oriented institutions to sell in anticipation of further declines. These
aggressive trading-oriented institutions included, in addition to hedge funds, a small number of pension
and endowment funds, money management firms and investment banking houses. This selling in turn
stimulated further reactive selling by portfolio insurers and mutual funds.
– Brady Report (1988)