Hedge Fund Vignette

Andy Green, CFA, and Sue Hutchinson, CFA, are considering adding alternative investments to the portfolio they manage for a private client. They have found that it is recommended that a large, well-diversified portfolio like the one that they manage should include a 5 to 10% allocation in alternative investments such as commodities, distressed companies, emerging markets, etc… After much discussion, Green and Hutchinson have decided that they will not choose individual assets themselves. Instead of choosing individual alternative investments, they will add a hedge fund to the portfolio. They decide to divide up their research by having each of them take a different focus. In their research of hedge funds, Green focuses on hedge funds that have the highest returns. Hutchinson focuses on finding hedge funds that can allow the client’s portfolio to lower risk while, with the use of leverage, maintain the same level of return. After completing their research into finding appropriate hedge funds, Green proposes two hedge funds: the New Horizon Emerging Market Fund, which takes long-term positions in emerging markets, and the Hi Rise Real Estate Fund, which holds a highly leveraged real estate portfolio. Hutchinson proposes two hedge funds: the Quality Commodity Fund, which takes conservative long-term positions in commodities, and the Beta Naught Fund, which manages an equity long/short portfolio that has the goal of targeting the portfolio’s market risk to zero. The Beta Naught Fund engages in short-term pair trading to capture additional returns while keeping the beta of the fund equal to zero. The table below lists the statistics for the client’s portfolio without any alternative investments and for the four hedge funds based upon recent data. The expected return, standard deviation and beta of the client portfolio and the hedge funds are expected to have the same values in the near future. The historical data shows that estimating a covariance between two portfolios with their respective betas and market variance produces fairly reliable and accurate estimates. The variance of the market return is 324(%2). Current Client Portfolio New Horizon Hi Rise Real Estate Quality Commodity Beta Naught Average 10% 20% 10% 6% 4% Std. Dev. 16% 50% 16% 16% 25% Beta 0.8 0.9 0.4 -0.2 0 Green and Hutchinson have decided to sell off 10% of the current client portfolio and replace it with one of the four hedge funds. They have agreed to select the hedge fund that will provide the highest Sharpe Ratio when 10% of the client’s portfolio is allocated to that hedge fund. As an alternative to investing 10% in one hedge fund, Green and Hutchinson have discussed investing 5% in the Beta Naught Fund and 5% in one of the other three hedge funds. This new 50/50 hedge fund portfolio would then serve as the 10% allocation in alternative investments for the client’s portfolio. Q1. Of the proposed hedge funds, which is most likely to introduce active risk into the client’s portfolio? A) The Beta Naught Fund. B) Hi Rise Real Estate Fund. C) New Horizon Emerging Market Fund. Q2. Which of the following is closest to the expected standard deviation of the client’s portfolio if 10% of the portfolio is invested in the Quality Commodity Fund? A) 9.6%. B) 14.2%. C) 16.0%.

  1. a 2) c

this hurts my head too much this late at night… and I think I done this one before but can’t remember now…go fig-

  1. C- Going long would introduce active risk into the portfolio… 2) A- The covariance between the two funds is beta1*beta2*variance of the maket. So the SD of porfolio is W1sqr*SD1sqr + …+2*W1*W2*Cov…so on formula… SG- I just approximate the answer for the Q2. I am not getting the answer on my calculator…Could you tell me the math please…

swaption, can you please post the answer to this vignette…i am getting B as the answer to the second question…

  1. calculate sharpe ratio with respect to the current portfolio as rinvestment-rport/sigma investment nh=11.11, hirise=0, qual=-0.25, betanaught=-0.24 nh has the highest sharpe ratio – so C? 2. quality has the same std deviation as the current portfolio. (0.9^2+0.1^2+2*.9*.1*-0.2)*16^2 = 200.704 = sigma^2 so sigma=14.17 ans b?

CP, Whats the covariance between the two portfolios? Don’t we need to calculate that… The -0.2 is the beta w.r.t to the market. We need to find the covariance between the two funds to calculate the SD of the combined portfolio Cov(1,2) = beta1*beta2*variance of market

crap. 1 I’ll take the other side and guess A for active mgmt since a mkt neutral fund would be probably the most active of these 3 in terms of picking winners on both sides of the mkt (i’m sure i’ll be wrong here). 2 crap. crap, crap, crap. just eyeballing- the SD of the mkt is 18 and for the fund is 16, so you i think can knock off A pretty fast. as for how to get the real answer from here, crap. cpk’s formula looks fancy. he’s probably right. simply eyeballing and not having that at my fingertips, i would’ve guessed C i think. i need to review alts and pm.

I have done the 2 * w1 * w2 * rho * sigma^2 there. rho I have used b to market of -0.2 Even if we went market model route and did cov(a,b) = betaa * betab * sigmam^2 you get 0.8 * -0.2 * 324 = -51.84 then substitute 0.9^2*256 + 0.1^2 * 256 - 2*0.9*0.1*(-51.84) = 200.5888 sigma = 14.16%

somebody please shoot me. I did PM last weekend and seem to have totally forgot everything. Swap can you please post the answer?

this looks like the Alt Investments portion

A B

is this alt inv or PM? Looks like PM to me. The alt inv portion on hedge funds is not this technical.

AI. Schweser makes it technical my friend. You will see many questions on real exam which will have material used from 2-3 different study sessions.

Just logged onto AF, correct answers are A and B.

vovo viva! (Borat style)

looks like I need to review Alt inv. I thought I was feeling decent but I just crapped my pants.

what is the answer explanation for A please?

Don’t have access to QBank in office. Will post the answer explainations from home, tonight. I was 0/2 right there.

do you have a question id?