{"id":34394,"date":"2023-11-07T18:35:33","date_gmt":"2023-11-07T18:35:33","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=34394"},"modified":"2024-04-11T12:24:43","modified_gmt":"2024-04-11T12:24:43","slug":"hedge-fund-strategy-portfolio-contributions","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/hedge-fund-strategy-portfolio-contributions\/","title":{"rendered":"Hedge Fund Strategy Portfolio Contributions"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/Xb3MnU0SR48\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe><\/p>\n<h2>Performance Contribution to a 60\/40 Portfolio<\/h2>\n<p>What is the potential impact of adding a hedge fund allocation to the traditional 60\/40 (stock\/ bond) portfolio?<\/p>\n<p>Consider a traditional 60%\/40% portfolio. 20% allocation of a hedge fund strategy group is added to the traditional portfolio. The resulting allocations for the combined portfolio are:<\/p>\n<p>$$ \\text{Stocks}=(0.60 \\times 100)+(0.20 \\times 100)=48\\% \\\\ \\text{Bonds}=(0.40 \\times 100)+(0.20 \\times 100)=32\\% $$<\/p>\n<p>It is generally true that when a hedge fund strategy is added to a portfolio:<\/p>\n<ul>\n<li>Total portfolio standard deviation decreases.<\/li>\n<li>Sharpe ratio increases.<\/li>\n<li>The sortino ratio increases.<\/li>\n<li>Maximum drawdown decreases in about one-third of the combined portfolios.<\/li>\n<\/ul>\n<p>Shows that hedge funds do the following to the traditional portfolio of bonds and stocks:<\/p>\n<ul>\n<li>Increase risk-adjusted return.<\/li>\n<li>Offer diversification.<\/li>\n<\/ul>\n<h3>Risk-Adjusted Measures of Performance<\/h3>\n<ul>\n<li><strong>Sharpe Ratio:<\/strong> Risk is defined as standard deviation and penalizes both upside and downside variability.<\/li>\n<li><strong>Sortino Ratio:<\/strong> Risk is defined as downside deviation and penalizes returns that fall below an inevitable minimum acceptable return. This is particularly relevant for hedge funds because of the left-tail risk.<\/li>\n<\/ul>\n<h4>Impact of 20% allocations to various hedge fund strategies added to traditional 60%\/40% portfolio.<\/h4>\n<p>$$ \\small{\\begin{array}{c|c|c|c} \\textbf{High Sharpe} &amp; \\textbf{High Sortino} &amp; \\textbf{Comparatively Higher} &amp; \\textbf{Sharpe and} \\\\ \\textbf{Ratios} &amp; \\textbf{Ratios} &amp; \\textbf{Sharpe and Sortino} &amp; \\textbf{Sortino Ratios} \\\\ &amp; &amp; \\textbf{Ratios} &amp; \\textbf{Significantly} \\\\ &amp; &amp; &amp; \\textbf{Enhanced} \\\\ \\hline \\text{EMN} &amp; \\text{Event-driven} &amp; \\text{Event-driven} &amp; \\text{FoFs} \\\\ \\hline \\text{Systematic futures} &amp; \\text{EMN} &amp; \\text{Global macro} &amp; \\text{Multi-strategy} \\\\ \\hline \\text{Global macro} &amp; \\text{Systematic futures} &amp; \\text{EMN} &amp; \\\\ \\hline \\text{Event-driven} &amp; \\text{L\/S Equity} &amp; \\text{Systematic futures} &amp; \\end{array}} $$<\/p>\n<h3>Risk Metric: Standard Deviation (SD)<\/h3>\n<ul>\n<li>FoFs<\/li>\n<li>EMN<\/li>\n<li>Dedicated short-biased<\/li>\n<li>Bear market-neutral<\/li>\n<li>Systematic futures<\/li>\n<\/ul>\n<p><strong>Explanation:<\/strong><\/p>\n<ul>\n<li>The capacity of these strategies to reduce risk was found to be significant.<\/li>\n<li>Some of the strategies were found to improve risk-adjusted returns significantly.<\/li>\n<\/ul>\n<h3>Small positive impact on decreasing SD of returns for the combined portfolio<\/h3>\n<ul>\n<li>Event-driven\/distressed securities<\/li>\n<li>Relative value\/convertible arbitrage.<\/li>\n<\/ul>\n<p><strong>Explanation:<\/strong><\/p>\n<ul>\n<li>Event-driven\/distressed securities: Take long positions in securities, and their outcomes can either be a success or a failure.<\/li>\n<li>Relative value\/convertible arbitrage: Often relies on leverage, which can become a risk during market stress.<\/li>\n<\/ul>\n<h3>Risk Metric: Drawdown<\/h3>\n<ul>\n<li><strong>Drawdown:<\/strong> Decline in value of the portfolio from its highest point (high-water mark) to any subsequent low point until a new high-water mark is achieved.<\/li>\n<li><strong>Maximum drawdown:<\/strong> The most significant decline in value from a high-water mark to a subsequent low point in a portfolio&#8217;s value.<\/li>\n<\/ul>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone wp-image-36166 size-medium_large\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown-768x599.png\" alt=\"\" width=\"768\" height=\"599\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown-768x599.png 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown-300x234.png 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown-1024x799.png 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown-1536x1199.png 1536w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown-400x312.png 400w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2023\/11\/Risk-Metric_Drawdown.png 1590w\" sizes=\"auto, (max-width: 768px) 100vw, 768px\" \/><\/p>\n<h3>Most Negligible Maximum Drawdown (Opportunistic strategies)<\/h3>\n<ul>\n<li>EMN<\/li>\n<li>Global macro<\/li>\n<li>Systematic futures<\/li>\n<li>Merger arbitrage<\/li>\n<\/ul>\n<p><strong>Explanation:<\/strong><\/p>\n<ul>\n<li>The conditional risk model can demonstrate that these strategies have a relatively low exposure to equity or credit risk during periods of market turmoil.<\/li>\n<li>They also have good liquidity.<\/li>\n<li>These strategies are an effective way to provide diversification in a traditional asset portfolio.<\/li>\n<\/ul>\n<h3>High Maximum Drawdown<\/h3>\n<ul>\n<li>L\/S Equity<\/li>\n<li>Event-driven\/ distressed securities<\/li>\n<li>Relative value\/ convertible arbitrage<\/li>\n<\/ul>\n<p><strong>Explanation:<\/strong><\/p>\n<ul>\n<li>The conditional risk model can show that these strategies are highly prone to equity and credit risk during market crises.<\/li>\n<\/ul>\n<blockquote>\n<h2>Question<\/h2>\n<p>How do the Sharpe and Sortino ratios differ in measuring risk-adjusted performance, and in what context is the Sortino ratio considered a superior performance measure for hedge fund strategies?<\/p>\n<ol type=\"A\">\n<li>The Sharpe ratio and Sortino ratio both penalize downside variability.<\/li>\n<li>The Sharpe ratio penalizes only downside variability, while the Sortino ratio penalizes both upside and downside variability.<\/li>\n<li>The Sharpe ratio measures risk as downside deviation, while the Sortino ratio measures risk as standard deviation.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p><strong>The correct answer is B.<\/strong><\/p>\n<p>This accurately describes the difference between the Sharpe and Sortino ratios in measuring risk-adjusted performance.<\/p>\n<p><strong>A is incorrect.<\/strong> The Sharpe ratio penalizes upside and downside variability, while the Sortino ratio focuses on downside variability.<\/p>\n<p><strong>C is incorrect.<\/strong> The Sharpe ratio measures risk as a standard deviation, not a downside deviation.<\/p>\n<\/blockquote>\n<p>Reading 38: Hedge Fund Strategies<\/p>\n<p><em>LOS 38 (i) Evaluate the impact of an allocation to a hedge fund strategy in a traditional investment portfolio.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"<p>\ufeff Performance Contribution to a 60\/40 Portfolio What is the potential impact of adding a hedge fund allocation to the traditional 60\/40 (stock\/ bond) portfolio? Consider a traditional 60%\/40% portfolio. 20% allocation of a hedge fund strategy group is added&#8230;<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[562,102],"tags":[],"class_list":["post-34394","post","type-post","status-publish","format-standard","hentry","category-alternative-investments","category-cfa-level-2","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Hedge Fund Strategy Portfolio Contributions - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"The Sharpe ratio penalizes upside and downside variability, while the Sortino ratio focuses on downside variability.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/hedge-fund-strategy-portfolio-contributions\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Hedge Fund Strategy Portfolio Contributions - 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