Volume 5, No. 3, Third Quarter 2007
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Practitioner's Digest
Practitioner’s Digest • Vol. 5, No. 3
The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.
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Insight
Will the Phillips Curve Cause WWIII?
“Insights” features the thoughts and views of the top authorities from academia and the profession. This section offers unique perspectives from the leading minds in investment management.
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Article
On the Relative Performance of Multi-Strategy and Funds of Hedge Funds
Recently, there has been explosive growth in two products from the hedge fund industry multi-strategy (MS) funds and funds of hedge funds (FOFs), both of which offer diversification across different hedge fund strategies. In well functioning markets, both investment vehicles should offer similar returns. Over the period 1994-2004, we find that MS funds outperform FOFs on a risk-adjusted basis by 2.6% to 4.8% per year on gross-of-fee and by 3.0% to 3.6% per year on net-of-fee basis. The superior performance of MS funds continues to hold even when we control for fund characteristics such as size, management and incentive fees, and other conventional control variables. Since FOFs underperform MS funds on both net- and gross-of-fee basis, their underperformance cannot be entirely explained by their double-layered fee structure. The question then is how MS funds and FOFs can co-exist in equilibrium in view of the significant differential in performance? We suggest that investors perceive greater agency risk in the structure of MS funds relative to FOFs and therefore require greater compensation for investing in MS funds. MS funds are able to generate these higher returns because they possess greater investment flexibility and are able to invest in less liquid assets. It is also possible that MS funds generate greater returns because managers with "better" ability self-select into joining MS funds and the competition among MS funds results in the rents from superior ability being passed on to the investors in the form of better returns. Controlling for the differences in agency risk, flexibility, and fee structure between MS funds and FOFs, our results suggest that self-selection by managers with superior ability in MS funds may be the driving force behind their superior performance relative to FOFs.
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Article
Active 130/30 Extensions: Alpha Hunting at the Fund Level
Active equity strategies that are highly benchmark-centric will generally have a minimal impact on fund-level volatility. Since most US institutional portfolios are overwhelmingly dominated by their equity exposure, any incremental tracking error will be submerged by the beta effect. Positive alpha opportunities from tightly beta-targeted strategies can therefore be particularly valuable because they can significantly increase the fund's total return with only minor increases in the overall volatility or other "beyond-model" forms of risk.
Active extensions strategies such as "130/30" portfolios are intrinsically benchmark-centric and can potentially lead to higher levels of active alpha. The expanded footings open the door to a fresh set of actively chosen underweight positions and provide a wider range of alpha-seeking opportunities for both traditional and quantitative management.
Active extension strategies can be designed to fit within a sponsor's existing allocation space for active US equity. With proper risk control, an active extension may entail tracking error that is only moderately greater than that of a comparable long-only fund.
A carefully implemented active extension can expand relationships with existing managers. A sponsor may wish to draw upon those active managers that have already been vetted in terms of their alpha-seeking skills, organization infrastructure, and risk-control procedures.
The preconditions for realizing any of these benefits are a credible basis for producing positive alphas in both long and short portfolios, a high level of risk discipline, an ability to minimize and/or offset unproductive correlations, and an organizational ability to pursue active extensions in a benchmark-centric, cost-efficient fashion. -
Book Review
Louis Bachelier's Theory of Speculation
“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.
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Case Study
Common Sense Investing
“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.