UNIVERSITY OF EAST ANGLIA School of Economics Main Series UG Examination 2017-18 ECONOMICS OF ALTERNATIVE INVESTMENTS ECO-6004B Time allowed: 2 hours Answer ALL questions from Section A and THREE questions from Section B. Notes are not permitted in this examination. Do not turn over until you are told to do so by the Invigilator. ECO-6004B Module Contacts: Dr Antony Jackson, ECO Copyright of the University of East Anglia Version 1
Page 2 SECTION A (Answer ALL questions from this section) 1 a) Define the Fundamental Law Of Active Management. [6 Marks] Portfolio Manager A is a macro hedge fund manager who rebalances her S&P500 Index Futures portfolio once per week. Her portfolio currently has an Information Ratio of 1.0. Portfolio Manager B is a specialist in the Pharmaceuticals sector, and takes positions in 5 stocks each quarter. His Information Ratio is 0.8. b) Given the information provided above, which portfolio manager is generating the best forecasts? [6 Marks] Portfolio Manager B decides to hire an analyst. The analyst will enable the portfolio manager to increase the number of positions he takes, while maintaining exactly the same quality of forecasts. c) Approximately how many extra stock positions per year must the portfolio manager take in order to raise the Information Ratio to that of Portfolio Manager A? [8 Marks] 2 A futures contract on oil has a notional of 1000 barrels. The six-month futures price of a barrel of oil is currently $100, and the initial margin requirement is $10,000 per contract. The maintenance margin requirement is $5,000 per contract. A Commodity Trading Advisor wishes to establish a long $1.5 million position in oil using the futures market. a) Calculate the advisor s total initial margin requirement. [5 Marks] b) Suppose that the six-month futures price of oil decreases by 6%. Calculate the advisor s new margin balance and the size of the exchange s margin call. [10 Marks] c) What are the benefits and costs of holding a futures contract on a commodity, rather than holding the underlying physical asset? [5 Marks] ECO-6004B Version 1
Page 3 SECTION B (Answer THREE questions from this section) 3 Compare the usefulness of the CAPM with the usefulness of multifactor return modelling when estimating the overperformance or underperformance of an alternative investments fund. [20 Marks] 4 Explain the Dummy Variable approach to dynamic risk exposure analysis. In this context, what is a down market beta? [20 Marks] 5 Describe two major approaches to valuing private commercial real estate. [20 Marks] 6 Why is an empirical test of market efficiency a joint hypothesis test? Discuss this problem in the context of market-neutral equity fund management. [20 Marks] END OF PAPER ECO-6004B Version 1
ECO-6004B: 2017/18 Main Series Feedback and Suggested Solutions Feedback The mean mark for the examination was 61.7%, and the median mark was 64.0%. The lower quartile mark was 53.0%, and the upper quartile mark was 74.0%. Please find below advice and suggested solutions. Section A Question 1a The Fundamental Law of Active Management states: Information Ratio = Information Coefficient Breadth, where the IR is the ratio of excess return relative to tracking error, the IC is the correlation between forecast returns and realized returns, and Breadth is the quantity of independent active bets in a portfolio. Question 1b Consider annual numbers. Portfolio Manager A 1.0 = IC 52 IC = 0.139
Portfolio Manager B 0.8 = IC 20 IC = 0.179 Portfolio Manager B is generating the best forecasts. Question 1c 1.0 = 0.179 Breadth Breadth = 31.25 The new breadth is 7.8 per quarter or, after rounding to the nearest integer, approximately 8 per quarter. This is an extra 3 positions per quarter. Question 2a The notional per contract is 1000 $100 = $100, 000 Number of contracts is $1, 500, 000/$100, 000 = 15 contracts Total initial margin is 15 $10, 000 = $150, 000 Question 2b On a $1,500,000 notional, a 6% fall implies a loss of 0.06 $1, 500, 000 = $90, 000 The advisor s new margin balance is $150, 000 $90, 000 = $60, 000 2
The maintenance margin requirement is 15 $5, 000 = $75, 000 The advisor is required to re-fund the account up to the initial margin requirement of $150,000, which implies the exchange s margin call is $150, 000 $60, 000 = $90, 000 Section B For these essay-style questions, one good structure to adopt is the following: 1. Summary 2. Technical Discussion 3. Critical Analysis Question 3 In the summary you could mention that this question aims to understand the returns of an investment strategy in terms of common risk factors. In the case of equity fund managers, as well as the CAPM risk factor, these common risk factors include momentum, short-term reversal, value, size, and volatility. In the technical discussion, take the opportunity to write down risk models for the CAPM and an alternative model such as the Fama-French-Carhart model or the Quantopian common-risks model. In the critical analysis section you may comment that the common risk factors have gradually been accepted by practitioners and academics over a long period, and that the evidence points to long-run returns to being exposed to these risk factors. These returns are in addition to the CAPM risk factor, so using the CAPM as the base risk model will tend to highlight many more strategies or anomalies as generating excess risk-adjusted returns. A really impressive answer will mention that inexpensive smartbeta products have been introduced to cater for demand for common risk factors, so multifactor models are most appropriate for identifying alpha that can realistically charge fees under the 2-and-20 model. 3
Question 4 In the summary section you may want to mention that the Dummy Variable approach is one model in the family of dynamic risk exposure models. This family of models can be used to measure the performance of a manager in up and down markets, or to assess their market timing ability. For the technical discussion, the effectiveness of market-timing strategies can be analyzed by a comparison of their average risk exposures to up markets and their average risk exposures to down markets. The equation below models different responses of the returns of a hedge fund to up markets and down markets: R i,t R f = α i + {[β i,d + (D 1 β i,diff )] (R m,t R f )} + ɛ i,t The dummy variable D 1 is set equal to 1 when R m,t R f > 0 and is set to zero when R m,t R f <= 0. The coefficient β i,diff is the difference between the fund s beta in up markets compared to its beta in down markets. For the critical analysis section, a natural extension is to consider another model in the dynamic risk exposure family, such as the Separate Regression or Quadratic Approach. These types of models also sit naturally in the Managed Futures space. Question 5 In the summary section, you may wish to briefly mention that there are two major approaches: the income approach and the comparables approach. In the technical discussion, you may wish to set up a discounted net operating income model V = NOI 1 (1 + r) + NOI 2 (1 + r) 2 + NOI 3 (1 + r) 3 + NOI 4 (1 + r) 4 + NOI 5 (1 + r) 5 + NSP (1 + r) 5 where NOI stands for Net Operating Income, and NSP stands for Net Sales Proceeds. The comparables section will be more descriptive and may include: Quality of the neighbourhood Quality of amenities, such as schools, doctors, and roads Proximity to beaches and the countryside 4
Proximity to pollution and landfill sites. The critical analysis section may make reference to hedonic pricing. Question 6 There are many ways to answer this question. Some possibilities are discussed below: The summary section could describe how the anomalies literature suffers from a joint-hypothesis problem, which means that we have to jointly write down an appropriate risk model (such as the Capital Asset Pricing model or the Quantopian Common-Risks model) and establish that the intercept term of the regression is greater than the risk-free rate. The technical discussion could include: A discussion of how the anomalies literature explores various violations of the efficient markets hypothesis (EMH). The EMH implies that the intercept term of our performance attribution analysis should be equal to the risk-free rate. A discussion of a long/short equity strategy, such as the social sentiment (twitter) strategy A discussion focussing on the empirical aspect of the question. In the module, we mentioned the R-squared of the overall regression equation and the t-statistics of the parameters. Again, given the wide subject area, there are many possibilities, many of which are already discussed above. For example, an answer could discuss the source of the risk premiums (liquidity, anomalies, behavioural hypotheses) or use Managed Futures as a contrast. 5