This timing problem is a common one for active managers. We saw other examples of this issue when we dis-
stock, they usually acknowledge that it is hard to know how long it will take for price to converge to intrinsic value.
While the classic hedge fund strategy may have focused on market-neutral opportunities,
as the market has evolved, the freedom to use derivatives contracts and short positions
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P A R T V I I
Applied Portfolio Management
funds pursue market-neutral strategies, a quick glance at the range of investment styles in
Table 26.1 should convince you that many, if not most, funds pursue directional strategies.
In these cases, the fund makes an outright bet, for example, on currency movements, the
outcome of a takeover attempt, or the performance of an investment sector. These funds are
most certainly not hedged, despite their name.
In Chapter 24, we introduced you to style analysis, which uses regression analysis
to measure the exposure of a portfolio to various factors or asset classes. The analysis
thus measures the implicit asset class exposure of a portfolio. The betas on a series of
factors measure the fund’s exposure to each source of systematic risk. A market-neutral
fund will have no sensitivity to an index for that market. In contrast, directional funds
will exhibit significant betas, often called loadings in this context, on whatever factors
the fund tends to bet on. Observers attempting to measure investment style can use these
factor loadings to impute exposures to a range of variables.
We present a simple style analysis for the hedge fund indexes in Table 26.2 . The four
systematic factors we consider are:
•
Interest rates: the return on long-term U.S. Treasury bonds.
•
Equity markets: the return on the S&P 500.
•
Credit conditions: the difference in the return on Baa-rated bonds over Treasury bonds.
•
Foreign exchange: the percentage change in the value of the U.S. dollar against a
basket of foreign currencies.
The returns on hedge fund index i in month t may be statistically described by
5
R
it
5 a
i
1 b
i1
Factor1
t
1 c1 b
i4
Factor 4
t
1 e
it
(26.3)
The betas (equivalently, factor loadings) measure the sensitivity to each factor. As usual,
the residual, e
it
, measures nonsystematic risk that is uncorrelated with the set of explana-
tory factors, and the intercept, a
i
, measures average performance of fund i net of the impact
of these systematic factors.
Table 26.2 presents factor exposure estimates for 13 hedge fund indexes. The results
confirm that most funds are in fact directional with very clear exposures to one or more
of the four factors. Moreover, the estimated factor betas seem reasonable in terms of the
funds’ stated style. For example:
•
The equity market–neutral funds have uniformly low and statistically insignificant
factor betas, as one would expect of a market-neutral posture.
•
Dedicated short bias funds exhibit substantial negative betas on the S&P index.
•
Distressed-firm funds have significant exposure to credit conditions (more positive
credit spreads in this table indicate better economic conditions) as well as to the
S&P 500. This exposure arises because restructuring activities often depend on
access to borrowing, and successful restructuring depends on the state of the
economy.
•
Global macro funds show negative exposure to a stronger U.S. dollar, which would
make the dollar value of foreign investments less valuable.
We conclude that, by and large, most hedge funds are making very explicit directional bets
on a wide array of economic factors.
5
This analysis differs in two important respects from style analysis for mutual funds introduced in Chapter 24.
First, in this application, factor loadings are not constrained to be non-negative. This is because,
unlike mutual
funds, hedge funds easily can take on short positions in various asset classes. Second, portfolio weights are not
constrained to sum to 1.0. Again, unlike mutual funds, hedge funds can operate with considerable leverage.
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