Investment Strategies and Performance Evaluation

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Questions and Answers

What percentage of topics on the final exam will come from materials covered since the last midterm?

60%

80%

40% (correct)

20%

What does the methodology for performance evaluation include?

Exploring venture capital structures

Evaluating the historical performance of mutual funds

Pre-lecture video (correct)

Assessing hedge fund strategies

What are students allowed to bring to the final exam?

Their textbooks

A financial calculator

Three note sheets (correct)

Practice exam papers

Which of the following topics is NOT listed under Performance Evaluation?

Investor Behavior Signup and view all the answers

Who is the guest speaker mentioned in the announcements?

Rodolfo Martell Signup and view all the answers

Which of the following is a question from the investor perspective?

Should I invest in hedge funds? Signup and view all the answers

Which areas do alternative investments include as listed in the agenda?

Private Equity Signup and view all the answers

What aspect is questioned from an economist's perspective in terms of fund managers?

Can they outperform the market on a risk-adjusted basis? Signup and view all the answers

What is the average alpha of mutual funds per year?

-1% Signup and view all the answers

What was a significant finding of Boyer et al (2019) regarding venture capital (VC) performance?

VC has a beta greater than 1 and an alpha approximately 0 Signup and view all the answers

Which investment product has not been shown to deliver alpha?

All of the above Signup and view all the answers

What is the reason attributed to the underperformance of mutual funds?

High fees associated with mutual funds Signup and view all the answers

How is real estate's performance characterized in relation to the S&P 500?

Highly correlated Signup and view all the answers

What has been observed about the performance of active mutual funds over time?

They experience persistent underperformance. Signup and view all the answers

What was the aggregate wealth loss for mutual fund investors over a 30-year period, according to recent research?

$1.02 trillion Signup and view all the answers

During the COVID-19 crisis, what percentage of active funds underperformed the S&P 500?

74% Signup and view all the answers

What characteristic differentiates private investments from public investments?

Private investments tend to have wider performance dispersion. Signup and view all the answers

What was the average return of active mutual funds during the 10-week period of the COVID-19 crisis?

-5.6% Signup and view all the answers

Why might private investments show higher returns compared to public investments according to common belief?

They often utilize leverage and risk-adjusted strategies. Signup and view all the answers

What conclusion can be drawn about past winners among mutual funds?

They do not have consistently better future returns than others. Signup and view all the answers

Which statement about active management during downturns is most accurate?

Most active managers struggle to outperform their benchmark during bad market times. Signup and view all the answers

What amount has been collected in performance fees by PE funds since at least 2006?

$230B Signup and view all the answers

What is the main reason for the persistence of high fees in PE funds?

Agency conflicts and complexity in measuring risk and returns Signup and view all the answers

What did Stafford (2022) find when comparing a portfolio of public stocks to PE funds?

The IRR of the new portfolio was 3% higher than that of PE’s. Signup and view all the answers

What did Korteweg and Nagel (2016) identify as a flaw in existing measures of venture capital returns?

They do not adjust for the high beta of venture capital. Signup and view all the answers

What was the overall finding on risk-adjusted basis for VC funds according to Korteweg and Nagel?

Slightly negative excess returns. Signup and view all the answers

What is the significance of the 'Burgiss' data provider in Stafford's research?

It collects and analyzes private equity fund-level cash flows. Signup and view all the answers

What type of return did Stafford (2022) specifically analyze when assessing the performance of PE funds?

Internal Rate of Return (IRR) Signup and view all the answers

How do PE funds generally compare to public equity indices since 2006?

They have about the same returns. Signup and view all the answers

What is a major challenge in estimating betas for alternative investments?

Illiquid assets may lack timely price information Signup and view all the answers

What is one implication of appraisal smoothing?

It can lead to inflated valuations that do not reflect true market conditions Signup and view all the answers

Why are customized benchmarks considered subjective?

They can vary significantly depending on the strategist's perspective Signup and view all the answers

What is a consequence of complex fee structures in investment management?

They make it difficult to accurately assess net performance after fees Signup and view all the answers

Which of the following best describes a common misconception about private equity portfolio returns?

They tend to follow a power law distribution Signup and view all the answers

What is a potential issue associated with hedge funds and return smoothing?

It can mask true performance and risk levels Signup and view all the answers

What is a significant challenge to risk measurement in alternative investments?

Impacts on valuations can negatively influence risk calculations Signup and view all the answers

What complicates benchmarking in alternative investment strategies?

Lack of widely accepted and comparable benchmarks Signup and view all the answers

What does a positive Jensen's Alpha indicate about a portfolio's performance?

The portfolio has outperformed the market after adjusting for risk. Signup and view all the answers

What is one of the main advantages of using Jensen's Alpha?

It adjusts for risk and indicates the value added by the portfolio manager. Signup and view all the answers

Which formula accurately represents Jensen's Alpha using CAPM?

$Jensen's Alpha = R_p - R_f + eta_p (R_M - R_f)$ Signup and view all the answers

What can lead to the misestimation of beta in a portfolio's evaluation?

Non-linear returns and illiquid assets. Signup and view all the answers

What is a significant disadvantage of evaluating individual funds solely based on Jensen's Alpha?

Alpha estimates are often imprecise, requiring long time series data. Signup and view all the answers

According to research, how much do active mutual funds generally underperform the market by annually?

By about 1%. Signup and view all the answers

The Fama French 3 model adds which factors to the assessment of Jensen's Alpha?

Small-minus-big and high-minus-low risk premiums. Signup and view all the answers

What is one challenge of using Jensen's Alpha in mutual fund evaluation?

Survivorship bias may affect the results. Signup and view all the answers

What does the term 'noise' refer to in the context of evaluating alpha?

Irregular fluctuations in reported returns. Signup and view all the answers

Which statement best describes the utility of Jensen's Alpha?

It can evaluate both funds and individual securities. Signup and view all the answers

Study Notes

Performance Evaluation

The course is FIN 367: Investment Management at the University of Texas at Austin.
The instructor is Shikhar Singla.
There will be a guest speaker, Rodolfo Martell, on Monday, December 2nd from 5:00 PM to 6:30 PM.

Announcements

There will be a comprehensive final exam covering 60% of the semester's topics and 40% since the last midterm.
The final exam format will be similar to previous exams.
Students may bring three note sheets (front and back) to the final exam; they do not need to be the ones used on previous exams.
Additional practice problems are available on Canvas.

Lecture Agenda

Topics include performance evaluation methodology, performance evidence, mutual funds, alternative investments, issues with alternatives, hedge funds, private equity, and venture capital.
A pre-lecture video is available.

Thought Questions

Investor perspective questions include how to evaluate fund performance, whether to invest in actively managed mutual funds, hedge funds, or alternative investments, and which funds to choose.
Economist perspective questions include whether fund managers can outperform the market, and whether markets are efficient. A caveat is provided that manager outperformance is evidence against efficiency, but lack of outperformance doesn't confirm efficiency.

Evaluating Returns

To evaluate high returns, ask three questions: risk adjustment, performance attribution, and luck vs skill.

Performance Evaluation Methods

Methods include universe comparison, Sharpe Ratio, Treynor Measure, Jensen's alpha (with different factor models), and Information Ratio.

Universe Comparison

This is the simplest and most common way to adjust returns.
Compare returns to a benchmark or universe of similar funds.
Examples include "fund beat its benchmark each of the past three years" or consistently performed in the top quartile.

Sharpe Ratio

This ranks performance based on the portfolio's risk premium per unit of risk.
The formula is (Rp - Rf) / σp, where Rp is the average portfolio return, Rf is the risk-free return, and σp is the volatility of the portfolio.

Treynor Ratio

This ranks performance based on the portfolio's risk premium per unit of systematic risk (beta).
The formula is (Rp - Rf) / βp, where Rp is the average portfolio return, Rf is the risk-free return, and βp is the portfolio's beta.

Information Ratio

This measures a portfolio's excess return relative to a benchmark, adjusted for the volatility of those excess returns.
The formula is (Rp - Rf) / σ(Rp-Rb) where Rp is average portfolio return, Rf is average benchmark return, and σ(Rp-Rb) is tracking error.

Which Approach is Preferred or Best?

Alpha is often the most appealing approach because it adjusts excess returns for systematic risk and known factors and is flexible.

Jensen's Alpha

Measures a portfolio's excess return relative to the expected return predicted by a risk model.
The formula using CAPM: Rp - [Rf + βp(RM - Rf)].
The formula using the Fama French 3 model: Rp - [Rf + βp(RM - Rf) + BSMBSMB + BHMLfHML].

Jensen's Alpha (Continued)

Positive alpha indicates outperformance, negative indicates underperformance.
It adjusts for risk and market performance and indicates the value added by the manager.
Alpha estimates are frequently noisy and require a long time series to measure accurately.

Section Summary

Alpha and performance relative to a benchmark are the most common ways to evaluate fund performance.
Noise and selection bias make evaluating individual funds difficult, but it's possible to evaluate portfolios of funds with specific characteristics.

Mutual Fund Performance

On average, mutual funds underperform the market by approximately 1% per year.
Underperformance is largely due to fees.
Past losers tend to continue underperforming.

Active Public Manager Snapshot

Underperformance rates of various fund categories (e.g., large cap, small cap, high yield) increased over time.

Investor Behavior

Outflows from domestic equity mutual funds occurred, while inflows into ETFs are observed.

What about during the bad times?

Active funds tended to underperform the S&P 500 during the COVID-19 crisis.

Alternative Investments

Discussion of challenges associated with alternative investments.

Private vs Public Performance

Private investments show higher returns than public investments compared to their risk
This is because of the common belief among industry, but the risk adjustment is not taken into account,

Private vs Public Reward vs Risk

Private investments have a higher return per unit risk than public investments (higher Sharpe Ratio).
This has driven the significant movement of Pensions into Alternatives.
There are questions about why private investments have lower standard deviation / volatility.

Challenges with Alternative Indices

Difficulties include valuation differences (infrequent pricing, vintage year, subjectivity), liquidity issues (illiquidity, limited data), structural diversity (varied investment structures, complexity), performance smoothing (appraisal smoothing, time lags), and benchmarking (lack of comparable benchmarks, subjective custom benchmarks, regulatory and compliance differences, varied regulations and disclosure requirements).

Estimating betas are harder with Alternative Investing

Linear model may not work well with non-linear returns and low-probability events (e.g., options, liquidity issues).
Illiquid assets may lack price information, which biases returns calculations).

Simple Smoothing Example

Examples of how stale data may affect return estimates, even for periods with market downturns

Estimation errors in beta change alpha

Estimating betas with alternative investments leads to potential errors, making it harder to accurately measure alpha.

Do Hedge funds generate alpha?

Industry view generally supports hedge fund ability to generate alpha, but academic literature suggests a more skeptical view, with decreasing performance and growing evidence of subpar performance compared to factors like fees.

Bollen, Joenväärä & Kauppila (2021): Hedge Fund Performance

Hedge fund performance has decreased since 2008 and has displayed evidence that regulatory changes and market condition changes explain the decline.

Does Private Equity Outperform?

Private equity returns are not observable, creating difficulties in risk-adjusting returns.
Industry common practice is to report IRR, but the appropriate benchmark selection, as well as reporting bias (downward volatility bias) remains a challenge

Kortweg (2019): Risk Adjustment in Private Equity Return

Studies found that leveraged buyout investments have generally earned risk-adjusted profits before and after fees, compared to a levered stock portfolio, but alphas has been declining with better measures of risk and adjusted returns.

Kortweg (2019) Risk Adjustment in private equity return

This study reviews the literature on risk-adjusted returns in private equity. Results show that risk-adjusted returns estimates vary by method, time period and data source.

Does VC outperform？

VC funds do not outperform the market when considering beta and risk factors.

Boyer et al. (2019): VC does not outperform

VC funds were not found to outperform when incorporating a new data source and considering previous issues in measuring beta.

Real estate is highly correlated with S&P 500

Real estate has a high correlation with the S&P 500, and annualized Sharpe ratios for real estate are much lower.

Summary

Mutual funds typically underperform the market by approximately 1% per year, with underperformance largely due to fees.
Hedge funds and VC funds, similarly, have not exhibited consistent outperformance after accounting for risk.
Alternative investments (like REITS) have correlations with market but do not routinely outpace the market either.
Passive management strategies tend to yield better risk-adjusted returns.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Test your knowledge on the key concepts of investment strategies and performance evaluation methods. This quiz covers topics from the final exam materials, including alternative investments, mutual funds, and crucial findings in financial research. Understanding these areas is essential for mastering investment performance metrics.