1. Asset Management Lecture 14

2. Outline for today Evaluating hedge funds Marking timing: are mutual funds successful or not? Style analysis for mutual funds

3. Evaluating Hedge Funds Hedge funds rarely serve as an investor’s overall portfolio. Capture temporarily mispriced securities Less concerned with diversification Alpha-driven Sharp-ratio is not appropriate for evaluation

4. Evaluating Hedge Funds When mixing a hedge fund H with a baseline passive portfolio M, the optimal position of the H in the overall portfolio P would be

5. Evaluating Hedge Funds When the hedge fund is optimally combined with the baseline portfolio, the improvement in the Sharpe measure will be determined by its information ratio:

6. An example of actual performance measurement Which portfolio to choose? If the portfolio stands for the entire investment fund If the portfolio is only a subportfolio of a larger fund If this is an active portfolio to be mixed with the index

7. Difficulties in evaluating hedge funds Risk profile and investment strategy change rapidly Investment in illiquid assets: liquidity premium and pricing error Long-term risk-return Survivorship bias

8. Market Timing market timing involves shifting funds between a market- index portfolio and a safe asset High-beta vs. low-beta strategy

9. Constant weight of the market index (60%) Approach 1

10. Market Timing Treynor and Mazuy: Test for a group of mutual funds but found little evidence

11. Constant weight of the market index (60%) Approach 1Approach 2

12. Market Timing Henriksson and Merton: D is a dummy =1 for r M >r f =0 other wise Found that funds on average are poor at market timing.

13. Style Analysis Introduced by W. Sharpe study of mutual fund performance Regress fund returns on indexes of a range of assets Style: the regression coefficient on each index R 2 : percentage of return variability attributable to style 1-R 2 : stock selection market timing (changes in asset-class weights) Over 90% of variation in return could be explained by the funds’ allocations to bills, bonds and stocks

14. Style Analysis An alternative performance evaluation based on CAPM Comparison with CAPM: CAPMStyle The market indexStyle indexes Theoretically prescribed passive portfolio Closely tracks the fund’s activity

15. Example: Fidelity’s Magellan Fund

16. Conclusion: The fund is well presented by three style portfolios. But, do not underestimate the role of stock selection and market timing! The intercept of the regression is actually 0.32% per month

18. Morningstar Premier source of information on mutual funds The risk-adjusted rating is ranked across funds in a style group and stars are awarded

19. 2nd case study Morningstar, Inc. Discuss the rapid changes in the mutual fund industry up to the end of 2008. Discuss Morningstar’s rating system. What are the pros and cons of Morningstar’s rating system? How would you like to improve it? Deadline: April 19 (Sunday)