Hedge funds try to take advantage of (see the discussion of ‘Long/Short Equity’
and ‘Short Selling’ in the next chapter).
Effective AIS risk management requires a sound understanding of how returns are generated and what risks come with these return sources. The limitations of quantita- tive measures of risk-adjusted returns have to be considered (e.g. as in the case of skewed return distributions). As already mentioned, it is generally useful to distinguish the following two (real) sources of returns (besides ‘luck’): risk premiums and man- ager skill. These two sources are by no means mutually exclusive. It takes skill to capture a premium effectively and to manage the related risk. By the same token, some strategies are based largely on a manager’s skill in forecasting price moves or detecting relative mispricings, which is often performed with the help of quantitative valuation models. One can argue that these strategies earn a ‘complexity’ (risk) pre- mium. Further, price anomalies and apparent Arbitrage opportunities are often related to different risk premiums.18Despite certain overlaps and ambiguities that come with this classification scheme, distinguishing ‘risk premium strategies’ from ‘pure skill strategies’ nevertheless provides a good framework for an analysis of the AIS Universe.
ance company, which is rewarded with a premium for insuring its clients that is higher than the expected average claim per insurance contract, premiums in financial markets are positive expected returns that exceed the ‘risk free interest rate’19 in exchange for accepting the possibility of a financial loss. Over time, risk premiums provide an inher- ent and permanent positive expected return, the source of which does not disappear if spotted by other investors (although it can fluctuate over time). The nature of its under- lying risk premium is directly related to a strategy’s risk profile. The risks and premiums vary among different strategies. It is important to understand the economic rationales for the premiums of each individual strategy sector. They are discussed in detail in Chapter 3. For ‘risk premium strategies’, manager skill primarily expresses itself through premium identification, proper timing and the appropriate risk management.
The existence of premiums as inherent sources of returns is most apparent for Relative Value and Arbitrage strategies (Fixed Income Arbitrage, Risk Arbitrage and Convertible Arbitrage). Note that the word ‘Arbitrage’ does not refer here to the strictest meaning of the word (which is ‘generating a profit without risk’). In this context, by ‘Arbitrage’, I mean ‘buying relatively undervalued securities and selling overvalued securities’. There is a risk involved here, specifically the risk that the undervalued securities become even cheaper and the overvalued ones more expensive. ‘Arbitrage’ strategies earn spreads (i.e. premiums) between market prices of two or more strongly related instruments as compensation for taking very particular risks such as company specific risk, FX risk, commodity price risk, credit risk, duration risk, liquidity risk and deal risk. Risk (Merger) Arbitrage returns, for example, are directly linked to the spread between the market price of the target company and the price offered by the acquiring com- pany and are earned in return for taking the risk that the deal does not go through. The following list summarizes different risk premiums and identifies for each one of them the particular strategies attempting to capture it:
■ equity Market risk premiums (Equity Market Timing, Long/Short Equity, Convertible Arbitrage)
■ corporate event risk premiums (Risk Arbitrage, Long/Short Equity, Distressed Securities, Regulation D)
■ risk transfer premiums (Futures strategies)
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■ complexity premiums or ‘efficiency’ premiums (Equity Market Neutral, Statistical Arbitrage, Fixed Income Arbitrage)
■ liquidity premiums (Distressed Securities, Regulation D)
■ duration risk premiums (Fixed Income Arbitrage)
■ credit risk premiums (Fixed Income Arbitrage, Regulation D, Distressed Securities, Convertible Arbitrage)
■ FX risk premiums (FX strategies, some Global Macro strategies).
Equity risk premiums are compensation for the ‘capital formation’ function that investors fulfil through buying companies’ stocks and thereby giving companies access to working capital. Investors take the risk of financial loss, for example, due to an economic downturn, less favourable earnings developments or bankruptcy.
According to the Capital Asset Pricing Model (CAPM) and related models, equity risk is twofold. First, broad market risk is related to the volatility of the broad market or industry sector. Second, corporate specific risk is the idiosyncratic risk of loss due to an adverse development, which affects the stock of a particular company (note that, according to the CAPM, idiosyncratic risk does not earn a risk premium).
Many Futures strategies, especially trendfollowing strategies, are related to an eco- nomic function that is very different from equity investments. Investors in Futures are willing to expose themselves to the natural risks of commercial hedgers, thereby pro- viding those hedgers with the possibility to transfer their undesired price risks. By fulfilling this function of risk transferspeculators in Futures markets earn a correspon- ding premium, which could alternatively be called ‘commodity hedging demand premium’. More details are provided in Chapter 3 in the sections on Futures strategies.
Many Arbitrage strategies earn premiums for providing market efficiency and price transparency. Their aim is to detect pricing inefficiencies through the application of (mostly proprietary) valuation models to complex financial instruments. It can be argued that their returns are based on a ‘complexity’ (or, alternatively, an ‘efficiency’) premium for taking the risk of mismodelling the underlying financial instrument and its complexity and thus suffering a loss. Further, investors who are willing to accept lower liquidityin their investments earn a liquidity premium. Such liquidity risk often goes together with credit risk. Credit and duration risk premiums are connected to investing in fixed income instruments with lower credit quality and longer maturity respectively.
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What are the sources of returns for FX strategies? Currency markets (at least for the major currencies) are considered the most liquid financial markets in the world, and the inter-bank FX market is often seen as the market that operates closest to complete efficiency. This high liquidity has to be generated by somebody with mon- etary incentives, which means the speculators. It can be argued that the (very strong) liquidity request of commercial participants in FX markets generates a return source for FX traders, as supply and demand from commercial players alone barely ever balance each other exactly. This argument is similar to the risk transfer premium in commodity markets. The return of FX strategies is thus a premium paid by commer- cial market players for the generation of liquidity and price continuity (see the discussion on currency strategies in Chapter 3 for more details). Another premium earned by certain FX strategies is related to the risk of a (stronger than expected) currency devaluation and expresses itself as a positive (interest rate) carry (i.e. the differential in interest rates) between two currencies. The corresponding strategy consists of buying a high yield currency and selling one with a low yield.
One problem for the evaluation of risk premium-based strategies is that, while they earn returns due to the assumptions of certain risks, empirical measures of these risks might be calculated for a time period that does not include a relevant
‘risk event’. This can lead to a severe underestimation of a particular strategy’s risk.
Risk premiums as a source of return are less (if at all) obvious for some opportunis- tic strategies like Global Macro, Short Selling and many Long/Short Equity strategies.
The returns of these strategies are rooted in the manager’s skill in forecasting price developments, detecting pricing anomalies and acting quickly on anticipated market moves. The underlying opportunities and market inefficiencies are usually temporary and quickly disappear when spotted by other investors. The greatest potential for these
‘pure skill-based’ strategies is where information is not freely available. As I mentioned before, the distinction between manager skill and risk premium as sources of return is not always absolutely clear. Manager forecasting skill and a ‘complexity premium’ can both be argued to be sources of returns for some opportunistic strategies.
Ideally, financial economists would prefer to develop a universe of fundamental risk factors that can explain the time series behaviour of AIS returns. For traditional investments much work has been dedicated to examining the components of active equity and bond manager performance and numerous studies have directly assessed
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their sources of return.20 Similarly, more recent research indicates that certain factors (return drivers) help to explain AIS performance patterns.21Some go even further and argue that ‘generic’ systematic trading programs (with no discretionary or skill-based input) can replicate most strategies’ returns (and subsequently say that the high fees for AIS managers are not justified).22The current academic thinking on how to evalu- ate AIS returns is to include ‘style factors’ (e.g. option-like payoffs) in the set of performance factors rather than just explain AIS return based on other asset returns.23
The detection of specific performance drivers for AIS strategies with the help of quantitative tools such as factor models has been subject to intense discussion and research in the academic and the financial community in recent years. Hedge funds are now often classified as either ‘long biased’, i.e. primarily influenced by the direction of international bond and equity markets (‘return enhancers’), or non-directional attempting to be less affected by the direction of the major finan- cial markets (‘diversifiers’). But the statistical significance of AIS factors models has to date been rather low. This is partly due to the short time series available for research. Empirical measures for some AIS risk factors may not yet sufficiently describe the significant losses after ‘big events’ which are part of many strategies’
risk profiles. Most AIS professionals agree that qualitative reasoning has to sup- plement such quantitative analysis. Schneeweiss et al. in a recent publication provide a good summary of the discussion on sources of AIS return.24