Question

1. Valuing hedge funds with standard mean-variance framework is inappropriate. Discuss this statement and suggest what other valuation models are appropriate for hedge funds .

2. Discuss the major issues with hedge funds indices and why understanding their flaws is critical to investors .

3. Discuss three merits of investing into managed futures during times of market crisis .

Answer 1

a)

It is important to point out that there are circumstances when meanvariance analysis is not appropriate. In particular, risk assessments cannot be done accurately using a second order (i.e. mean-variance) approach.

In assessing risk, we are interested in the probability that a given fund has a large negative return in the next period. If the fund's returns are normally distributed, that this probability is determined by the mean and the standard deviations. But when returns are not normally distributed (as is true for hedge funds), the first two moments (i.e. mean and standard deviation) are not sufficient to give an accurate probability. [We may be able to use Chebychev's inequality to bound the probabilities. But these bounds are very loose and not very useful.]

The situation becomes even more complex if we need to access the probability of a large loss over multiple time periods.

A Valuation method for Hedge fund is discounted cash flows method (DCF)

Discounted Cash Flow Method

The discounted cash flow method projects future cash flows expected to be generated via carried interests or performance fees and discounts them at a rate of return commensurate with the risk inherent in realizing the cash flows. This method requires making assumptions regarding the hedge fund’s or private equity fund’s required rate of return, investment holding period, and GP cash flows which are then discounted to present value.

The two most important components in a discounted cash flow of valuation are:

• Projected cash flows
• Discount rate

b)

ISSUES WITH HEDGE FUND INDICES AND HOW IT IS CRITICAL FOR INVESTORS-

1.The key point is that for practical reasons investable indices can only offer access to a very limited number of hedge fund managers.

2.The age and accuracy of data in the indices also varies widely. Over half of index providers do not seek to verify data provided them by the underlying managers. This raises serious questions about the reliability of such data; a manager losing money has no incentive to reveal this fact, particularly if they are seeking to attract new investors. And even if the data is accurate it is always out of date by the time the indices compile and publish it.

3.The shortcomings of hedge fund indices do not end there. One of the strongest arguments is favour of buying index exposure derives from portfolio theory. A broad and representative index like the FTSE All Share or S&P 500 is an efficient portfolio, capturing optimal risk and return characteristics for investors who want market exposure. But hedge fund indices do not possess this set of properties.

c)

merits of investing into managed futures during times of market crisis

1.

Portfolio Diversification

Managed futures funds have proven to be uncorrelated to stocks and bonds, as well as other alternative asset classes, over time, thus offering true diversification to a portfolio. In fact, of all the alternative mutual fund categories, the managed futures category has provided the greatest correlation benefit over the last five years (a period chosen to correspond with the growth in alternative mutual funds). Low correlations with other assets means that when included in a diversified portfolio, managed futures funds should reduce overall volatility. Reducing volatility is important because of its positive effect on compounding and the fact that investors are more likely to stay the course when they don’t have to suffer large swings in performance.

2.

Downside Risk Management and Added Source of Returns

Due to the ability of trend following managed futures strategies to short asset classes experiencing downward trends, and the ability of counter trend strategies to generate positive returns regardless of market direction, managed futures strategies have the potential to protect capital during volatile or downward-trending markets.

3.

Harvesting Fear and Uncertainty in the Market

As alluded to previously, many managed futures funds follow market trends. That means that managers purchase assets that are trending higher while shorting securities that are trending lower.