Equity Hedge Funds

Question 1

1. Name the three major types of equity hedge funds and describe their typical systematic risk exposures.

Answer 1

• Equity long/short hedge funds
• Equity market-neutral fund
• Short-bias funds

Question 2

2. Describe the role of a market maker in the context of taking and/or providing liquidity in a market with anxious traders.

Answer 2

• A market maker is a market participant that offers liquidity, typically both on the buy side by placing bid orders and on the sell side by placing offer orders. A market maker meets imbalances in supply and demand for shares caused by idiosyncratic trade orders from anxious traders. Typically, the market maker’s purpose for providing liquidity is to earn the spread between the bid and offer prices by buying at the bid price and selling at the offer price.

Question 3

3. Why is an empirical test of informational market efficiency a test of joint hypotheses?

Answer 3

• The test is a joint hypothesis of the appropriateness of the particular model of returns (in determining what constitutes an abnormal return) and a test of whether a particular investment has generated statistically significant abnormal returns.

Question 4

4. What is standardized unexpected earnings and how is it used?

Answer 4

• Standardized unexpected earnings (SUE) is a measure of earnings surprise, with some measure of unexpected earnings in the numerator and some measure of earnings volatility in the denominator.

Question 5

5. What have empirical studies generally concluded about the relationship between the net stock issuance of a firm and the subsequent returns of the firm’s shareholders?

Answer 5

• There is evidence that positive or negative net stock issuance is one of the most profitable anomalies. Companies that issue large amounts of new shares, such as more than 20% of the shares currently outstanding, frequently see their stock price substantially underperform the market.

Question 6

6. What is the name of the measure that describes managerial skill as the correlation between managerial return predictions and realized returns?

Answer 6

• The information coefficient, which measures managerial skill as the correlation between managerial return predictions and realized returns

Question 7

7. In the context of the fundamental law of active management, what is a nonactive bet?

Answer 7

• Nonactive bets are positions held to reduce tracking error rather than to serve as return-enhancing active bets. In other words, these are not active bets in the sense that they are intended to add alpha to the portfolio; rather, they are added to keep the active manager’s return from straying too much from the benchmark.

Question 8

8. What is the name of the modelling approach that combines the factor scores of a number of independent anomaly signals into a single trading signal?

Answer 8

• Multiple-factor scoring models, which combine the factor scores of a number of independent anomaly signals into a single trading signal.

Question 9

9. Consider a skilled manager implementing a pairs trading strategy. What is the concern that tends to limit the size of the positions that the manager might take in attempting to increase expected alpha?

Answer 9

• The limits to arbitrage, which refers to the potential inability or unwillingness of speculators, such as pairs traders, to hold their positions without time constraints or to increase their positions without size constraints. Very large positions with high degrees of leverage increase the probability of financial ruin and the inability to survive short-term displacements.

Question 10

10. What distinguishes mean neutrality from variance neutrality inequity market-neutral strategies?

Answer 10

• Mean neutrality is when a portfolio is shown to have zero beta exposure or correlation to the underlying market index. In other words, when the market experiences a move in one direction, mean-neutral portfolios are no more likely to move in the same direction as in the opposite direction. Variance neutrality is when portfolio returns are uncorrelated to changes in market risk.