These funds realized an annualized return of 31 percent on average, from through the peak. The funds in this category sustained average annualized losses of 14 percent since the peak. The previous point presented how few did respond to the reversal of the overall market. Hedge funds tend to go long less liquid stocks and short more liquid stocks, favoring small-cap and value stocks, especially in periods of stress. Because hedge funds target underresearched stocks trading in less efficient markets, they are more likely to invest in a smaller-cap stock than a larger-cap stock.
In contrast, traditional managers, typically measured against a market cap—weighted benchmark, are significantly more likely to invest in a largercap stock. Finally, statistically driven approaches used by many hedge funds tend to favor value-based valuations. It is difficult for managers who do not fundamentally consider their structural biases to proactively manage these biases. Although it is difficult to quantify the degree to which hedge funds did respond to the shifting performance of both value and small cap, anecdotal evidence suggests that they did not.
Given the historical beta of 0. The actual 7. Overdiversifying results in diversifying away the valuable idiosyncratic risk and concentrating the equity exposure. The more diversified a portfolio of hedge funds gets, the greater the correlation to the equity markets —based on the HFR database see Figure 2. Consequently, a highly diversified portfolio of hedge funds has a 0.
The conclusion is that overdiversification destroys value. This strongly suggests that new managers have been more cognizant of their market environment. He also recognized the risk of excessive leverage, stating that it could literally throw the earth off its course. As in mechanical systems, well-deployed financial leverage can greatly enhance performance. However, excessive leverage can be ruinous.
Risk leverage defines the sensitivity of the returns in a portfolio construction to those of the underlying market. If you remember your high school physics, there are multiple types of levers. Similarly, in the financial world, there are multiple forms of leverage. Construction leverage is a manifestation of how the securities are combined in a portfolio construction. Instrument risk reflects the intrinsic risk of the specific securities selected for example, an equity option on Cisco is significantly more risky than an equally sized investment in a 1-year Treasury bond.
Remember that risk derives from volatility, the fact that returns are uncertain. As risk comes from uncertainty, it is by definition not well-behaved or easily described.
Therefore, there are a wide variety of ways to measure risk such as standard deviation, semi-deviation, drawdown, and VaR. The hedge fund industry has generally focused on the annualized standard deviation of monthly returns as a percent of equity as the most common metric of risk. Which of the following four portfolios has the greatest risk? Each portfolio has an aggregate beta of 2. The first portfolio achieved this through selecting risky securities, in this case securities with high internal leverage. The second portfolio achieved this through borrowing leverage, the third through notional funding leverage, and the fourth through construction leverage.
No one method of introducing leverage is inherently better than the others—they are just different. Which portfolio has the greatest risk? The first four ways are through varying levels of borrowing leverage, and the fifth is through notional leverage. It is the leverage created by augmenting the equity capital invested in the fund by borrowing at rates relatively close to the risk-free rate.
The invested capital is the sum of the absolute value of the market value plus the margin value of futures to be discussed later of all the positions in the construction. The invested capital is also equal to the equity capital plus the borrowed funds.here
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If the fund is not fully invested, the invested capital is less than the equity capital and the borrowing leverage is negative net cash position. If the fund does borrow funds, the invested capital will be greater than the equity capital and the borrowing leverage is positive. The typical borrowing leverage will vary significantly depending on the risk of the asset see Figure 3. These instruments are listed in Figure 3.
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The amount of these are expressed as the notional value. Futures Exchange-traded securities that provide exposure to equities, fixedincome instruments, currencies, or commodities by depositing a relatively small margin requirement Forwards OTC instruments that provide exposure to equities, fixed-income instruments, currencies, or commodities by depositing a relatively small margin requirement Swaps OTC instruments, with customized negotiated terms, traded in a market governed by International Securities Dealers Association Notional leverage is also equal to the difference between the cash equivalents the market value of cash instruments that would represent the equivalent risk exposure minus the invested capital.
Option leverage. Options including swaptions can create a significant amount of option leverage. Option leverage results from the fact that options can provide exposure to the underlying security, per dollar of invested capital, that is significantly greater than that provided by investing in the cash security. Delta expresses how much the value of the option will change as a result of changes in the value of the underlying security. Figure 3. Futures and forwards can create a high level of futures leverage. Futures are exchange-traded instruments in which one agrees to pay a specific price in the future hence the name for some underlying instrument.
The underlying instrument can be: An equity single stock futures were recently introduced An equity index A bond An interest rate An exchange rate A physical commodity One earns profits if the future price is less than the value of the underlying instrument at the time the future expires. One sustains losses if the future price is greater than the value of the underlying instrument at the time the future expires. This is the amount of invested capital an investor would have to commit were the investment made in the cash market.
The exchange sets the margin requirements for each contract.
In contrast to futures, where the exchange sets the margin requirements, the issuing party sets the margin requirements for forwards. Swap leverage. Swaps are OTC instruments issued by broker dealers.
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The most common swaps are interest rate swaps, in which the dealer, acting as counterparty, agrees with the client to swap one cash stream for another. The parties typically agree to swap the coupon from a fixed-rate bond to one with variable rates. For example, a five-year swap pays out a fixed rate of the current five-year swap rate the equivalent cash flows of the coupons of a 5-year Treasury plus a spread and receives the LIBOR floating rate that would be current at the time of each of the payments in fact, there are many alternative mechanisms for the variable rate to reset.
The risk of a swap is approximately equivalent there is a relatively small amount of credit risk to repoing the practice of purchasing a security by using the security as collateral to borrow money a Treasury bond. As swaps are generally percent notionally financed at the time of issue, they result in a significant amount of swap leverage.
There is an increasing use of credit default swaps in the financial markets. These are instruments in which a counterparty seeking credit protection agrees to pay a premium to the protection seller for the right to be compensated in the case of a default of the reference issuer. When managers think about internal security leverage they are typically interested in the sensitivity of the performance of the specific security to changes in the broad market.
For example, in the equity world, managers speak of the beta to the market. Risk does not directly tie to cash equivalent exposure. Similarly, an investment in a high-beta stock such as Cisco with a beta of 1. Therefore, a stock with a beta of 1. Construction Leverage If there were no diversification in a portfolio, the risk of the portfolio would equal the sum of the risks of the individual positions if there were no diversification the correlation among all the positions would be 1, and there effectively would be only one position.
This phenomenon is construction leverage. Recall from Chapter 2 that diversification is good, as it reduces risk without reducing returns. Furthermore, it is good to target idiosyncratic risk, often by hedging long positions with short positions. These two hedge fund practices can significantly reduce the overall portfolio risk of a portfolio. For example, both of the portfolios in Figure 3. In the first portfolio, both positions are long positions. The second portfolio combines a long position in ExxonMobil with a short position in ChevronTexaco.
The risk of the first portfolio is almost three times that of the second because of construction leverage. What Is the Right Amount of Leverage? There is no simple answer to this tough question.
The ultimate measure of leverage is the overall relationship between risk and equity capital. Another cautionary note is that many equity managers spooked by two years of poor returns subsequently reduced the risk of their portfolios by putting significant amounts of equity capital in cash. Holding cash is an extremely inefficient approach to risk management, however.