Catherine Marco is a portfolio manager with Mouton Investments, Inc., a regional money management firm. She is considering investments in alternative assets and decides to research the following three questions about long-short strategies and hedge funds:
(1) How can the alpha generated from a long-short strategy in one asset class be transported to another asset class?
(2) What are the three major quantifiable sources of risk that a fund of hedge funds manager must consider in risk monitoring?
(3) For a fund of hedge funds, how does risk-based leverage differ from accounting-based leverage?
a. Formulate one correct response to each of Marco's three questions.
Marco decides to explore various hedge fund investment strategies and reviews the following three strategy components:
i. Buy stocks after positive earnings surprise announcements, anticipating that the stock price will rise in the short term.
ii. Establish appropriate long and short positions in stocks of companies that have announced a merger or acquisition or are rumored to be considering such a transaction.
iii. Use neural networks to detect patterns in historical data.
b. Identify the hedge fund investment strategy that is best characterized by each of the three strategy components reviewed by Marco.
Following her research, Marco applies her findings to the situation of an individual client.
This client currently holds only traditional equity and fixed income investments and is willing to consider investing in alternative assets to lower the risk of his portfolio.
Marco forms the following five conclusions about investing in alternative assets for this client:
i. Investing in a fund of hedge funds is likely to increase the client's portfolio diversification and allow the client's portfolio to have exposure to a wide variety of hedge funds that may not otherwise be available to the client.
ii. A lack of transparency and the fund manager's inability to add value through portfolio construction are both disadvantages of investing in a fund of hedge funds.
iii. Because a directional hedge fund is expected to exhibit a lower dispersion of returns than a nondirectional hedge fund, a directional hedge fund is a more appropriate investment for this client.
iv. One appropriate hedge fund investment strategy for this client is a macro hedge fund, which is likely to provide increased returns with a relatively low standard deviation of returns.
v. Another approach that is consistent with the client's objectives is to use an equitized long-short strategy, which can be expected to neutralize market risk.
c. Judge whether each of Marco's five conclusions is correct or incorrect. If incorrect, give one reason why the conclusion is incorrect.