Risk Management and Investment Management

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 Total Framework
Portfolio Management

Portfolio Performance
Risk Management
and Investment Portfolio Risk Management
Management
Hedge Fund

Illiquid Assets
Portfolio Management
Portfolio Construction Process ★★ 性质

Current portfolio

Alphas Covariance
Transactions cost Active risk aversion

Inputs Portfolio
Construction

Techniques
Screens Stratification

Linear programming Quadratic programming
Portfolio Construction Techniques ★★★ 性质
Screens Simply choose assets based on raw alpha.

① Builds on screens.
② Ensuring that each category or stratum of assets is
represented in the portfolio.
Stratification ③ Divide the stocks in categories (e.g., economic
sectors, big/medium/small) and mimic the screening
exercise.

Attempts to construct a portfolio closely resembles

Linear Programming benchmark by using characteristics as industry, size,
volatility, and beta.

① Builds on linear programming.

② Explicitly considering alpha, risk, and transactions
Quadratic Programming costs.
③ Requires a great many more inputs than the other
portfolio construction techniques.
Portfolio Performance
Return-Based Portfolio Performance ★★★ 性质、计算
Geometric average
Time-Weighted Return 1
1  rG   1  r1   1  r2  ...  1  rn   n

① Internal rate of return (IRR)

Dollar-Weighted Return ② The rate of return at which the present value of cash
inflows equals the present value of cash outflows.

Risk-Adjust Performance Measures ★★★ 性质、计算

E  RP   RF E  RP   RF
Sharpe Ratio SP  Treynor Ratio TP 
σP βP

E  RP   RF E  Rp  - E  RB 
Sortino Ratio SOR  Information Ratio R
σL (RP ) σ ep

Jensen’s Alpha αP  E  RP   RF  βP  E  RM   RF 
Techniques to Measure the Market Timing Ability ★★ 性质

Market Timing
The ability to predict the future direction of market and shifting
funds between the market index portfolio and risk-free assets
depending of whether the market will outperform the risk-free
assets.
No Market Timing
Market Timing
Ability Assuming no market timing, and a constant beta, the security
characteristic line will be straight line with a constant slop.

Constant Slope
rP - r f
rp  rf  a  b  rM  rf 

rM - r f
Techniques to Measure the Market Timing Ability ★★ 性质

Market Timing (Treynor and Mazuy)

① The investor is able to accurately time the market and is shifting
the funds in to the market when it does well and withdraws
and puts funds in safe assets when the market in going
downwards.
② As the market returns increase, the portfolio beta will also
increase, resulting in a curved line.
Market Timing
rP  rf  a  b  rM  rf   c  rm  rf   eP
2
Ability
③The squared term represents the market-timing factor. A
positive c is an indication of the fund manager’s timing ability.

rP - rf Market Timing
Beta increases with expected
market excess return.

rM - rf
Techniques to Measure the Market Timing Ability ★★ 性质

Market Timing (Henriksson and Merton)

① This approach assumes that the beta of the portfolio can take
only two values: a large value if the market is expected to do
well, otherwise a smaller value.
rP  rf  a  b  rM  rf   c  rM  rf  D  eP

② D is a dummy variable. D = 1 when rM > rf, otherwise D = 0.

Market Timing
③ The portfolio’s beta is b in bear market and b + c in bull market.
Ability
A positive c is an indication of the fund manager’s timing ability.

r P - rf
Market Timing
Only two values of beta

rM - r f
Performance Attribution ★★★ 性质、计算
How much of the performance (excess
Asset returns above benchmark) is N

Allocation attributable to the selection of the right  w

j 1
P,j  w B,j  RB,j
asset classes
How much is attributable to selection
Security
of right sector or security within an N

 R  RB,j  w P,j
Selection
asset class.
P,j
j 1

Style Analysis ★★★ 性质

Uncover the investment style of the portfolio manager: the regression

Properties
slopes are used to infer the investment style of the manager.
Portfolio Risk Management
Portfolio VaR ★★★ 性质、计算
Individual VaR VaR of an individual position in isolation.

① VaR of the portfolio.

Diversified VaR ② Takes into account the VaR P  VaR 2
1  VaR 2 ρ  0
2

diversification effect. VaRP  VaR1  VaR 2 ρ  1

Change in a portfolio VaR that occurs

VAR
Marginal VaR from an additional one unit MVARi   βi
investment. P

Change in VaR from the addition of a Incremental VaRi

Incremental VaR
new position.  MVaRi  Wi

① Amount a portfolio VaR would

change from deleting that Component VaRi
Component VaR position in a portfolio.
② By construction, component VaRs  MVaRi  Wi*
sum to portfolio VaR.
Portfolio Risk Management ★★★ 性质、计算
Global Minimum Portfolio : Ri  R f R j  R f
Optimal Portfolio : 
MVaRi  MVaR j MVaRi MVaR j

Risk Budgeting ★★★ 性质

Examine the contribution each position makes to the
Across Asset Classes
portfolio VaR

① If the tracking error of the managers are independent of

each other, it can be shown that the optimal allocation
is achieved with the following formula:
Across Active Manager
IRi   portfolio' s TEV 
weight i 
②
 to 1. The remainder
IR  manager ' s TEV
p sum
The weights may not  of the
weight can be allocated to the benchmark
Policy Mix and Active Risk ★★ 性质
Risk from the policy mix is from the chosen portfolio weights, and active risk is from
individual managers deviating from the chosen portfolio weights.

Funding Risk ★★★ 性质、计算

Surplus at Risk
① Surplus is the difference between the value of
E  S   E  A   E  L  the assets and the liabilities.
② Funding risk is measured as potential shortfall
Surplus at Risk  E  S   z    S in surplus over the horizon, this is sometimes
called surplus at risk.

Liquidity Duration ★★ 性质、计算

It is an approximation of the number of days necessary to dispose of a portfolio's holdings

without a significant market impact.
number of shares of a sec urity
LD  [desired max daily volume(%)  daily volume]
Hedge Fund
Introduction of Hedge Funds ★★★ 性质
1. Private versus public
① Historically, hedge funds are private investment vehicles not
open to the general investment public.
② Consequently, hedge funds face less regulation than publicly
traded mutual funds.
Hedge Funds
2. Ability to take short positions
versus Mutual
Funds Typically hedge fund managers generate profit from both long as
well as short positions.
3. Freedom to use high leverage
4. Ability to employ derivatives
Introduction of Hedge Funds ★★★ 性质

1. Survivorship Bias
Few hedge-fund databases maintain histories of funds that have
shut down, partly for legal reasons, and partly because the primary
users of these databases are investors seeking to evaluate existing
managers they can invest in.
2. Self-Selection Bias
If a manager operates several hedge funds, it is questionable
Bias in Hedge
whether the poor performing ones will find their way into
Fund Databases
databases. In other words, there may well be a tendency to “put
the best face forward”.
3. Backfill Bias
① A related and important form is sometime referred to as the
“instant history” bias.
② When a new fund enters the database some of its performance
history during its incubation period is incorporated without
clear distinction from the live performance data going forward.
Hedge Fund Trading Strategy ★★★ 性质、计算
① For a stock deal, the bidder offers to
exchange each target share for X shares
of the bidder.
② In a fixed exchange ratio stock merger,
Merger Arbitrage
one would long the target stock and
short the acquirer’s stock.
③ The principal risk is usually deal risk,
Event-Driven should the deal fail to close.
Strategies ① Invest across the capital structure of
companies subject to financial or
operational distress or bankruptcy
proceedings.
Distressed Securities
② Focus on mis-pricings caused by
expected restructuring, reorganization,
legal or regulatory issues, or corporate
transactions.
Hedge Fund Trading Strategy ★★★ 性质
Exploiting inefficiencies and price
Fixed Income Arbitrage anomalies between related fixed income
securities.
Build long positions of convertible and
other equity hybrid securities and then
Relative
hedge the equity component of the long
Value
Convertible Arbitrage securities positions by shorting the
Strategies
underlying stock or options of that
company. Interest rate, volatility and credit
hedges may also be employed.
Invest in both long and short sides of
Long/Short Equity
equity markets.
Hedge Fund Trading Strategy ★★ 性质
Take more short positions than long
positions and earn returns by maintaining
Dedicated Short Bias
net short exposure in long and short
equities.
Invest in currencies, debt instruments,
Niche Emerging Market equities and other instruments of
Strategies developing countries’ markets.
Return behavior suggests that different
funds apply different trading strategies
Equity Market Neutral with a similar goal of achieving almost
zero beta(s) against a broad set of equity
indices.
Hedge Fund Trading Strategy ★★ 性质
Managed Focus on investing in listed bond, equity, commodity futures
Futures and currency markets, globally

Directional ① Focus on identifying mispricing in equity, currency,

Strategies interest rate and commodity markets.
Global
② Employ a top-down global approach to analyze how
Macro
political trends and global macroeconomic events may
affect the valuation of financial instruments.

Hedge Fund Risk ★★★ 性质

① More liquid assets should exhibit less serial autocorrelation.
Liquidity ② A Q-statistic is used as a summary measure of the overall statistical
Risk significance of autocorrelations.
③ This create two biases: Low correlations; Low volatility.

Style ① Changes in the risk factor exposures

Drift ② Changes in the overall risk of the fund
Risk Management of Hedge Fund ★ 性质

① Are heterogeneous;

② Hedge funds invest in illiquid assets;

③ Most employ leverage;

Risk
Management ④ Some have high turnover;
Challenges ⑤ Exhibit a lack of transparency;

⑥ Survivorship bias is a major consideration when hedge funds

are evaluated as a group. This could significantly exaggerate

their returns.
Due Diligence ★★ 性质
① Strategy
Due Diligence Process
② Ownership
Of
Investment Management ③ Track record
④ Investment management

① Risk
② Security valuation
Due Diligence Process ③ Portfolio leverage and liquidity
Of ④ Tail risk exposure
Risk Management Process ⑤ Risk reports
⑥ Consistency of the fund terms with the investment
strategy
Due Diligence ① Internal control assessment
On ② Documents and disclosure
Operating Environment ③ Service provider evaluation
Due Diligence ★★ 性质
① Revenues and expenses
② Sufficiency of working capital
Due Diligence Process ③ Existence of budgets
Of ④ Computation of breakeven points
Business Model Risk ⑤ Ability to increase investment asset base
⑥ Existence of key person insurance
⑦ Existence of a succession plan
① Existence of related-party transactions
② Illiquidity
Due Diligence Process
③ Litigation
Of
④ Unreasonably high (stated) investment returns
Fraud Risk
⑤ Personal trading by the manager of the same or
similar securities as those hold by the fund
Illiquid Assets
Reporting Biases ★★★ 性质
① Survivorship bias. Survivorship bias results from the tendency of poorly performing
funds to stop reporting.
② Selection Bias. Sample selection bias results from the tendency of returns only to be
observed when underlying asset values are high.
③ Infrequent trading. With infrequent trading, estimates of risk-volatility, correlation, and
betas are too low when computed using reported returns.

Harvest Illiquidity Premiums ★★★ 性质

① Allocating a portion of the portfolio to illiquid asset classes like real estate (passive
allocation).
② Choosing more illiquid assets within an asset class.
③ Acting as a market maker for individual securities.
④ Engaging in dynamic factor strategies at the aggregate portfolio level. This means taking
long position in illiquid assets and short positions in liquid assets to harvest the illiquidity
risk premium.