Absolute Risk

Convertible Arbitrage Strategy

Directional Strategies
Distressed Security Strategy
Emerging Markets Alternative Funds
Equity Market-neutral Strategy
Event-driven Strategies
Fixed-income Arbitrage Strategy
Global Macro Strategy
High-yield Bond Strategy
Kurtosis
Maximum Drawdown
Merger Strategy
Relative Value Strategies
Risk Arbitrage Strategy
Short Bias Strategy
Long/Short Equity Strategy
Skew
Time To Recovery
1
 Vocabulary
Advantages of Alt
Review questions
Strategies

2
 001

Week Topic Readings

Ch 13
1A Fundamental and Technical Analysis
Ch 14
1B Company Analysis
Ch 15
2 Introduction to the Portfolio Approach
Ch 16
3 The Portfolio Management Process

4A Test 1 September 26th Ch 13 - 16

Ch 17
4B Mutual Funds: Structure and Regulation
Ch 18
5 Mutual Funds: Types and Features
Ch 19
6 Exchange-Traded Funds

7 Alternative Investments, Benefits, Risks & Structure Ch 20

8A Test #2 Ch 17 – 20 Tues October 31st

Week Topic Readings
8B Alternative Investments Strategies & Performance CH 21
9 Other Managed Products Ch 22

10 Structured Products Ch 23
Ch 24
11A Canadian Taxation
Test 3 Ch 21 -24November 21
11B Canadian Taxation
12A Fee-Based Accounts Ch 25
12B Working with the Retail Client Ch 26
13A Working With the Institutional Client Ch 27
13B Test 4 Fri August 11th Ch 25 - 27
14 Book your Final Exam and write it by December 14th All
 Russian Default Risk
One of the big questions looming in the economic war
against Russia: what happens to its sovereign bonds? The
Russian government has borrowed about $49 billion in
dollar- and euro-denominated bonds, and owes a series of
interest payments to bondholders in the coming
months, Axios' Kate Marino writes.
Why it matters: If Russia defaults on its debt, it will play
out differently than sovereign defaults of the past — and
investors are watching for signs that it could ripple out
into a broader market dislocation as Russia's 1998 ruble
debt Muting
defaultthe systemic worry somewhat, Russia’s only a
did.
small part of emerging market (EM) indexes.
In the U.S., its bonds have been held mainly by long-only EM
mutual funds (as opposed to levered hedge funds), while
Western banks appear to have
minimal exposure to Russian assets on the whole.

5
 Due Diligence

the Alternative Investment Management Association (AIMA)

published AIMA Due Diligence Considerations for Retail
Investment Advisors. The publication provides a list of the top
due diligence questions for retail investment advisors to use
when considering investment in hedge funds and liquid
alternatives:
• Investment manager questions
• Strategy questions

6
 INVESTMENT MANAGER QUESTIONS
• What is the background and experience of the investment
manager and the investment team?
• What is the governance surrounding the investment
manager and investment team?
• What are the features of the investment manager’s
compliance culture?
• What risk management frameworks are in place
(independent reporting lines, operational risk management,
conflicts of interest, etc.)?
• Are the members of senior management of the investment
manager, the portfolio manager and/or the fund directors
personally invested in the fund? 7
 STRATEGY QUESTIONS
• What is the fund’s investment objective and principal investment
strategies?
• Have the objectives of the investment strategy changed in the past
five years?
• From where are the underlying positional data, market data and
any underlying models sourced for this strategy? Position limits?
• Who makes the portfolio management decisions and how are they
made?
• Performance history? In what type of markets would this strategy
be expected to outperform or underperform?
• What method(s) does the investment manager use to measure the
total risk of a portfolio using this strategy? 8
 Absolute Risk

Absolute risk is defined as the total

variability or volatility of returns. Total
variability incorporates all sources of risk
embedded in returns, including first- and
second-order risks, and does not
distinguish between upside and downside
volatility.

9
 Absolute risk is defined as the total variability or volatility of
returns. Total variability incorporates all sources of risk
embedded in returns, including first- and second-order risks, and
does not distinguish between upside and downside volatility.

To calculate the annual standard deviation from the

monthly standard deviation, the monthly standard
deviation is multiplied by the square root of 12. For
example, based on the monthly standard deviation of
3.93%, the annual standard deviation is 13.61%. The
standard deviation gives a good indication of the
dispersion of returns only when returns are or are
approximately normally distributed.

10
If returns are normally distributed, then the following
relationships hold:
• approximately 68% of all returns lie within one standard
deviation of the average or expected return;
• approximately 95% of all returns lie within two standard
deviations of the average or expected return;
• approximately 99% of all returns lie within three
standard deviations of the average or expected return.

11
 Skew

Skew measures the extent to which a

distribution is tilted toward negative
or positive returns. Positive skew
indicates a tendency to obtain
returns above what is observed with
the normal distribution, and
conversely, negative skew indicates a
tendency to obtain returns below the
normal distribution.

12
13
A left-skewed distribution
usually appears as a right-
leaning curve.

14
 The distribution is said to be right-
skewed, right-tailed, or skewed to the right,
despite the fact that the curve itself appears
to be skewed or leaning to the
left; right instead refers to the right tail
being drawn out and, often, the mean being
skewed to the right of a typical center of the
data. A right-skewed distribution usually 15
appears as a left-leaning curve
16
17
 Leptokurtic: More values in the
distribution tails and more values close
to the mean (i.e. sharply peaked with
heavy tails) Platykurtic: Fewer values in
the tails and fewer values close to the
mean (i.e. the curve has a flat peak and has
more dispersed scores with lighter tails).
18
 Kurtosis

Like skewness, kurtosis is a statistical measure that is

used to describe distribution. Whereas skewness
differentiates extreme values in one versus the other
tail, kurtosis measures extreme values in either
tail. Distributions with large kurtosis exhibit tail data
exceeding the tails of the normal distribution (e.g., five
or more standard deviations from the mean).
Distributions with low kurtosis exhibit tail data that
are generally less extreme than the tails of the normal
distribution.

For investors, high kurtosis of the return

distribution implies the investor will experience
occasional extreme returns (either positive or
negative), more extreme than the usual + or - three
standard deviations from the mean that is predicted by
the normal distribution of returns. This phenomenon is19
known as kurtosis risk.
 Excess Kurtosis

The term excess kurtosis refers to a metric used

in statistics and probability theory comparing
the kurtosis coefficient with that of a
normal distribution. Kurtosis is a statistical
measure that is used to describe the size of the
tails on a distribution. Excess kurtosis helps
determine how much risk is involved in a
specific investment. It signals that the
probability of obtaining an extreme outcome or
value from the event in question is higher than
would be found in a probabilistically normal 20

distribution of outcomes.
If alternative strategy fund returns were normally
distributed, the risk rankings using measures of downside
risk would be no different from rankings based on
measures of absolute risk.

But since alternative strategy fund returns are not

normally distributed and have a greater tendency to
have negative skew and positive excess kurtosis, the
focus on downside risk becomes all the more important.

21
 Drawdown, Maximum Drawdown, and
Time to Recovery

Drawdowns represent peak-to-trough declines during a specific

period of time. They are expressed as a percentage of the peak
value. Individual drawdowns measure the percentage loss an
investor would have realized if he or she had bought the fund at
its peak and subsequently sold it at its lowest point. A new
drawdown begins only when the fund surpasses its previous peak
value.

Time to recovery is the number of months required to move from a

trough to a new peak. Some alternative strategy fund managers and
analysts define time to recovery as the time from peak to trough to peak.
22
 Sharpe Ratio

The Sharpe ratio measures excess returns generated above

the risk-free rate per unit of risk as measured by the standard
deviation

For example, over the three years ended December 2018, the
S&P/TSX Composite Index had a Sharpe ratio of 0.16. When
compared to the ABC fund’s Sharpe ratio of 0.09, it appears
that the ABC fund has under-performed the S&P/TSX
Composite Index on a risk-adjusted basis.
23
 Risk in Order

Exposure to Market
Hedge Fund Categories Specific Strategies
Direction
Equity market neutral
Relative Value Strategies Low Convertible arbitrage
Fixed-income arbitrage

Merger or risk arbitrage

Event-Driven Strategies Medium Distressed securities
High-yield bond

Long/short equity
Global macro
Directional Strategies High Emerging markets
Managed futures
Dedicated short bias
26
 Why use them?

1. To diversify the portfolio

2. To add alpha
3. To increase the portfolio’s absolute
return nature

27
 Relative Value Strategies

• Attempt to profit by exploiting inefficiencies or

arbitrage opportunities in the pricing of related
stocks, bond or derivatives
• Hedge funds using these strategies generally have
low or no exposure to the underlying market
direction
3 main types
1. Equity Neutral ( Pairs Trading)
2. Convertible arbitrage
3. Fixed Income arbitrage (Credit spread, Yield
28

Spread)
 Equity Neutral Strategies

• Also known as pairs trading

• designed to exploit inefficiencies in the equity market by
creating simultaneously long and short matched equity
positions of approximately the same size
• Goal is to generate returns that are not related to the
direction of the market
• The success of the strategy is dependent on the manager’s
ability to analyze equities and identify opportunities
• The goal is to have very low or zero beta
• The expected return is mostly or entirely alpha – return
created by the manager

29
 Equity Neutral Strategies

• Match a long position and a short position in two

stocks with a very high correlation
• Trade is based on historical correlation – this is
what drives the strategy’s profits
• Looking for stocks that are affected by the same
economic factors
• By having a high correlation – and being on both
sides of the trade, we don’t care which way the
market moves – we can make money either way –
hence the name market neutral

30
 Relative Value Strategies

Equity Market Neutral:

 Goal is to generate positive returns regardless of

market direction.

 Manager creates a neutral position in the portfolio

holdings:

long and short equity positions are created

simultaneously of approximately the same size

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Equity Neutral Strategies - Example

32
Equity Neutral Strategies - Example

33
Equity Neutral Strategies - Example

34
Equity Neutral Strategies - Example

35
Equity Neutral Strategies - Example

36
37
 Relative Value Strategies – Convertible Arbitrge

Convertible Arbitrage:
 Looking for a mispricing between convertible
securities and their underlying stock.
 Typically involves going long the convertible
bond of a security and short the common stock
of the same security.
 Profits are generated from the bond income and
the interest rebate of the short sale, while the
principal is protected from directional moves.

38
 Relative Value Strategies – Convertible Arbitrge

Convertible Arbitrage:
 Looking for a mispricing between convertible
securities and their underlying stock.
 Typically involves going long the convertible
bond of a security and short the common stock
of the same security.
 Profits are generated from the bond income and
the interest rebate of the short sale, while the
principal is protected from directional moves.

39
 Relative Value Strategies – Convertible Arbitrge

Convertible Arbitrage:
 In a declining stock market with interest
rates rising, gains on being short on the stock
will outweigh the loss on the convertible bond
– still receiving coupon payments
 In a rising market with falling rates, the gain
on the bond should be greater than the loss
on the stock – amount of stock being shorted
will be less than conversion amount

40
Relative Value Strategies – Convertible Arbitrge

41
Relative Value Strategies – Convertible Arbitrge

42
Relative Value Strategies – Convertible Arbitrge

43
 Relative Value Strategies

Fixed-Income Arbitrage:
 Attempts to profit from price anomalies between related
interest rate instruments.
 Often, extremely high leverage is normally used to help
generate returns that exceed transaction costs.
 Long Term Capital Management’s fund used fixed income
arbitrage.
 In one of its trades, the fund was long Russian bonds
against UK and US bonds. In August 1998, the Ruble was
devalued while US and UK interest rates fell, meaning they
lost on both ends of the trade.

44
 Credit Spread Arbitrage

Bond portfolio managers rely primarily on two skills:

• The ability to anticipate the future direction of interest rates
(given that all bond prices are a function of interest rates)
• The ability to price the credit risk of the bond under
consideration correctly

Credit risk manifests as yield spread for the bond, which is the
difference between the market yield to maturity (YTM) of the
risky bond and that of a sovereign government bond with a
similar term to maturity.

45
 Yield Spread Arbitrage
In a yield spread arbitrage strategy, the manager is only
concerned with the yield curve of a single issuer. Due to the
liquidity and vast choice of bonds, the yield spread arbitrage
strategy is normally only implemented with a sovereign yield
curve (BoC or the U.S. treasury).
Managers of yield spread strategies attempt to add value by
demonstrating their skill at forecasting the shape of the yield
curve at a future moment. The manager implements the
strategy to realize a targeted rate of return based on the
expected yield curve.
For example, if the manager believes that the yield curve
will flatten (when the difference between the yield on the
longer-dated security and the shorter-dated security
becomes smaller), they will sell the shorter-dated security
and purchase the longer-dated security. It is important to
note that managers of this strategy can and do use any
combination of terms found on the yield curve. 46
Yield Spread Arbitrage

47
 Yield Spread Arbitrage

In a yield spread arbitrage strategy, the manager is

only concerned with the yield curve of a single
issuer. Due to the liquidity and vast choice of bonds,
the yield spread arbitrage strategy is normally only
implemented with a sovereign yield curve (BoC or the
U.S. treasury).

Managers of yield spread strategies attempt to add

value by demonstrating their skill at forecasting the
shape of the yield curve at a future moment. The
manager implements the strategy to realize a targeted
rate of return based on the expected yield curve. 48
 Credit Spread Arbitrage

Bond portfolio managers rely primarily on two skills:

• The ability to anticipate the future direction
of interest rates (given that all bond prices are
a function of interest rates)
• The ability to price the credit risk of the bond
under consideration correctly

Credit risk manifests as yield spread for the

bond, which is the difference between the
market yield to maturity (YTM) of the risky bond
and that of a sovereign government bond with a 49

similar term to maturity”

 Event Driven Strategies

• Seek to profit from unique events, such as

mergers, acquisitions, stock splits and share buy
backs
• These strategies have medium exposure to the
underlying market direction

3 main types

1. Merger and Acquisition

2. High Yield Bonds
3. Distressed Securities

50
 Event-Driven Strategies

Merger or Risk Arbitrage:

 Invests in event-driven situations such as mergers,
takeovers, reorganizations, or leveraged buyouts.
 Strategy involves buying the stock of the target
company and shorting the purchasing company’s
stock.
 The objective is to capture the spread between the
two stocks which will converge as the merger date
nears.
 The returns are generally uncorrelated with the
direction of the markets. 51
Merger
If the acquiring firm’s earnings per share decreases post-merger
due to a lower earnings contribution from the targeted firm, the
deal is considered to be dilutive.

If the acquiring firm’s earnings per share increases post-merger

due to the strong earnings contribution of the targeted firm, the
deal is considered to be accretive. Mergers are often dilutive for
the acquiring firm until positive synergies that result from the
merger take effect.

52
 Event-Driven Strategies

Distressed Securities Funds:

 Distressed securities sell at deep discounts largely
because the majority of institutional investors
cannot own below investment grade securities.
 Results generally not dependent on the direction of
the markets, as their prices are already low.
 Objective is to profit from a lack of understanding
on the part of market participants of the true value
of a deeply discounted security.

53
 Event-Driven Strategies
High-Yield Bonds:
 In this strategy, the fund manager buys high yield
debt of a company – i.e., junk bonds.
 The manager believes that the firm may become a
potential takeover target subsequently upgrading
the credit of the firm and increasing the value of
the debt instrument.

54
 Directional Strategies
• Make a bet on anticipated moves in the market
• Have high exposure to movements in the overall
market

55
 Time-series Momentum Strategy

This strategy uses fundamental analysis and

historical prices (i.e., technical analysis) to
identify market trend signals. The strategy
assumes that assets with a positive trend will
continue to have a future positive trend, and
that assets with a negative trend will have a
future negative trend. Once the analysis is
complete, the manager will go long the
positive-trend assets and short the negative-
trend assets. 56
 Cross-sectional Momentum Strategy

This strategy takes positions in pairs of securities

based on relative signals. The manager will take a
long position in the security with relatively
positive momentum, and short the security with
relatively negative momentum. This strategy is
usually executed on single stocks, and the long
and short positions are equal (so that general
market movements have no effect on the pair
traded.

57
 Directional Funds

Long/Short Equity:
 Manager will either have a net long or net short
exposure to the market.
 The long or short position is taken depending on the
directional bet of the market.
 Ideally, in a rising market good long positions will rise
more than the market and good short positions will
rise less.
 In a down market, good short selections will fall more
than the market and good long selections will fall less.

58
 Directional Funds

Net Market Exposure:

Net exposure = (Long Exposure – Short Exposure) /
Capital )
Example:
 Manager believes the shares of BBD are
undervalued relative to the shares of EMB (ERJ-N).
 The manager has $100,000 in capital.
 She goes long $100,000 in BBD and short $70,000
in EMB.
What will be the net exposure?
Long or Short?
59
 Directional Funds

Net Market Exposure = (Long – Short Exposure) /

Capital
 The manager will go long BBD and short EMB.
 Let’s say the manager goes long $100,000 in BBD and
short $70,000 in EMB.

Net exposure
= $100,000 – $70,000 / $100,000
= 30%

 The fund is 30% ‘long’.

‘What if’ the stock market declines by

15%?
60
Net exposure
= $100,000 – $70,000 /
$100,000
= 30%
 The fund is 30% ‘long’.
 ‘What if’ the stock
market declines by
15%?

Market down
15%
Market down
15%

long $100.00 $ (15.00)

long $100.00 $ (15.00)
short $70 $ 10.5
short $70 $ 10.5
$ (4.50)
So loss is 4.5% 61
https://www.youtube.com/watch?v=8SJw9SVw6CU

62
 Directional Funds
Net Market Exposure:

• Assets that are not within the hedge structure

constitute the funds “net market exposure”.

• While assets within the hedged structure are

exposed to stock picking risk, assets outside the
hedged structure are exposed to stock picking
and market risk.

63
 Directional Funds

Global Macro Funds:

 Rather than make investments on micro events

affecting specific companies these funds make bets
on macro events.

 Aims to profit from changes in global economies,

typically brought about by shifts in government
policy that impact interest rates, in turn affecting
currency, stock, and bond markets.

64
 Directional Funds

Global Macro Funds:

 Most aggressive type of hedge fund can have very

high returns but also high risk.

 Uses leverage and derivatives to accentuate the

impact of market moves.

 Utilizes hedging, but the leveraged directional

investments tend to make the largest impact on
performance.
65
 Directional Funds

Emerging Market Funds:

 Equity and fixed-income investing focusing on emerging

markets around the world.

 As many emerging markets do not allow short selling or

have viable derivative markets, performance is volatile.

66
 Directional Funds

Dedicated Short Bias Funds:

 Up to 1997 category was known as “dedicated

short sellers”.

 Bull run reduced the number of these funds and

caused the rest to change strategy to short bias.

 Short bias requires the fund’s net position to be

short.

67
 Directional Funds

Managed Futures Funds:

 Commodity Trading Advisors who invest in listed
financial and commodity futures and futures
options.
 Returns from managed futures show a low to
low/negative correlation with portfolios of stocks
or stocks/bonds.
 Also known as commodity pools and can be sold as
mutual funds to the general investor.

68
 Hedge Fund Categories

Relative Value Hedge Funds

 Profit by exploiting irregularities or discrepancies in
the pricing of related stocks.

Event-Driven Hedge Funds

 Profit from unique, particular events such as
mergers, acquisitions, stock splits, and buybacks.

Directional Hedge Funds

 Bet on anticipated movements in the market prices of
equities,
fixed-income securities, foreign currencies and
commodities.

69
 Hedge Fund Categories

 Long/Short Equity  Convertible Arbitrage

 Fixed-Income Arbitrage  Equity

Market Neutral

 Merger or Risk Arbitrage  Distressed

Securities

 High Yield Funds  Global Macro

Funds

 Emerging Markets  Managed Futures

 Dedicated Short Bias Funds of Funds

70
 Funds of Hedge Funds (FoHF)

Is a portfolio of hedge funds.

The manager decides which funds to invest in and

the amount of investment within each.

Two main types:

 Single-strategy, multi-manager funds
 Multi-strategy, multi-manager funds

71
 FoHF - Advantages

 Due diligence
 Reduced volatility
 Professional management
 Access to hedge funds
 Ability to diversify with a smaller
investment
 Manager and business risk control

72
 FoHF - Disadvantages

 Additional costs
 No guarantees of positive returns
 Low or no strategy diversification
 Insufficient or excessive diversification
 Additional sources of leverage

73
 Due Diligence

Because hedge fund managers have tremendous

flexibility in the types of strategies they can employ, the
manager’s skill is more important in hedge funds than in
almost any other managed product.

This makes the amount of due diligence performed

before recommending or investing in a hedge fund of
significant importance.

Thus, understanding the particular strategy the

manager is employing and the manager’s track 74

record is critical to the success of the investment

Alternative Assets

Commodities
Collectibles
Infrastructure
Private equity

75
76
77
Global Macro Managers Typically Use Either Of Two
Different Styles Of Analysis

Discretionary managers Discretionary managers construct

portfolios using a top-down analysis
approach, analyzing the world
economy. Their goal is to predict the
direction of underlying markets and
asset classes.

Systematic managers Systematic managers construct

portfolios using a bottom-up
analysis approach, employing the
use of models and algorithms on
large sets of economic data. Their
goal is to predict the movement of
financial market prices.

78
 Managed Futures
Most managed futures managers follow a strategy called trend-
following, otherwise known as a momentum strategy. In contrast
to traditional investing strategies that focus on value or growth,
managers of trend-following strategies seek out securities that
have moved in one direction for an extended period.

Some managers, known as commodity trading

advisors (CTAs), manage futures exclusively.

A commodity pool operator (CPO) is a money manager or

investment fund (called a commodity pool) that oversees
investments made in commodities securities such as futures and
options contracts, or foreign exchange (forex) contracts. The
commodity pool operator may also make trading decisions or
advise other members of the commodity pool on potential
investments for the pool.
79
Commodity Pool Operator (CPO)

A CPO is similar to a
commodity trading advisor (CTA),
but a CTA is an individual or firm
that instead provides
individualized advice regarding
the buying and selling of
commodities-related securities.

80
Time-series This strategy uses fundamental analysis and
momentum historical prices (i.e., technical analysis) to identify
strategy market trend signals. The strategy assumes that
assets with a positive trend will continue to have a
future positive trend, and that assets with a negative
trend will have a future negative trend. Once the
analysis is complete, the manager will go long the
positive-trend assets and short the negative-trend
assets.
Cross-sectional This strategy takes positions in pairs of securities
momentum based on relative signals. The manager will take a
strategy long position in the security with relatively positive
momentum, and short the security with relatively
negative momentum. This strategy is usually
executed on single stocks, and the long and short
positions are equal (so that general market
movements have no effect on the pair traded.)

81
The four major futures categories are as follows:
1. Commodities, such as gold, crude oil, coffee, orange juice, and
soybean futures
2. Currencies, such as US dollar, yen, and euro futures
3. Stock Index, such as Dow, S&P, and NASDAQ index futures, and
4. Fixed Income, such as US Treasury bond and foreign sovereign
bond futures
Managed futures have the following advantages:
• High liquidity
• Low friction costs (futures trade with ‘tight’ bid/ask spreads)
• Complete price transparency
• Facilitates “direct” access to underlying risk (e.g., gaining exposure
to gold bullion prices through a futures contract, rather than equity or
82
fixed-income investing in a gold mining company)
 Multi-Strategy Hedge Fund vs Fund Of Funds (FOF).

The multi-strategy manager is a single manager who operates

several different hedge fund strategies, whereas a FOF manager
invests capital across a range of strategies managed by different
managers.

Fund-of-funds investing has an increased diversification benefit

because the manager can invest with more managers and
strategies than a single manager would be able to. Moreover,
FOF investing further reduces concentration and operational risk.

83
 In Order of Liquidity

Most alternative mutual funds utilize the strategies listed

in the first six bullet points 84
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