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MIS 4500 (31)

Commodity Investments.docx

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Management Info. Systems
MIS 4500
Pourang Irani

Commodity Investments:  Types: o Direct commodity investment: cash market purchase involving actual possession and storage o Indirect commodity investment: say as equity in companies specializing in production  Benchmarks: o Reuters Jefferies/Commodity Research Bureau (RJ/CRB) Index – uses unequal fixed weights based on perceived relative importance o Goldman Sachs Commodity Index (GSCI) – arithmetic averaging of monthly component returns; total return version and spot version o Dow Jones-AIG Commodity Index (DJ-AIGCI) o S&P Commodity Index (S&PCI)  Historical performance: o On stand-alone basis, commodities have lower Sharpe ratio than U.S. and world bonds and equities o Correlations w/ traditional asset classes are close to zero o Return components: spot return / price return; collateral return; roll return (positive for long in backwardation market)  Investment characteristics: o Understand investment characteristics of commodities on sector- or individual- commodity level o Special risk characteristics:  Unusually low correlations w/ equities and bonds  Price risk in periods of financial and economic distress  Long-term growth in world demand in limited supply: long-term trend growth  Generally business cycle sensitive  Determinants of return:  1. business cycle-related supply and demand:  2. convenience yield: embedded consumption timing option; inverse relationship b/w level of inventories and convenience yield o Samuelson effect: term structure of forward price volatility generally declines w/ time to expiration (mismatched supply and demand at shorter horizons, but equilibrium in longer horizons)  3. Real options under uncertainty:  Inflation: ―natural‖ sources of return; protection against unexpected inflation  Positive correlation w/ unexpected inflation  Roles: o Potent risk diversifier o Inflation hedge: classes such as livestock and agriculture exhibit negative correlation w/ unexpected inflation as measured by monthly changes in inflation rate; storable commodities directly linked to economic activity exhibit positive correlation w/ changes in inflation and have superior inflation-hedging properties Hedge Funds:  Types: o Equity market neutral: roughly equal exposure long and short o Convertible arbitrage: o Fixed-income arbitrage: mispricing based on term structure of interest rates or credit quality o Distressed securities: o Merger arbitrage: o Hedged equity: not equity market neutral o Global macro: o Emerging markets: o Fund of funds  Groups: o Relative value o Event driven o Equity hedge o Global asset allocators o Short selling  Fees: o AUM fee and incentive fee o High-water mark  Initial Lock-up period: maybe 1 to 3 yrs  Benchmarks: o CISDM of the University of Massachusetts o Credit/Suisse/Tremont o EACM Advisors o Hedge Fund Intelligence Ltd. o o HFR o MSCI o Dow Jones Hedge Fund Strategy benchmarks o HFR hedge fund indices o MSCI Hedge Invest Index o Standard & Poor’s Hedge Fund Indices  Differences in major manager-based hedge fund indices: o Selection criteria: which hedge funds are included o Style classification: o Weighting scheme: o Rebalancing scheme: o Investability:  Absolute return vehicles? Defined as having no benchmark, while estimates of alpha must be made relative to a benchmark o Can establish comparable portfolios using 1. single factor or multifactor methodology; 2. optimization to create tracking portfolios w/ similar risk and return characteristics  Historical performance: o HFCI has higher Sharpe ratio than any other reported assets; correlation of 0.59 w/ S&P 500 o b/c equity hedge funds load on similar return factors as S&P 500, offer less diversification than many relative-value strategies and can be more rightly considered return enhancers  Interpretation Issues: o Biases in Index Creation: concern is whether index reflects actual relative sensitivity of hedge funds to various market conditions, such that each index provides info on true diversification benefits of underlying hedge fund strategies o Relevance of Past Data on Performance: best forecast of future returns is one that is consistent w/ prior volatility and not one that is consistent w/ prior returns o Survivorship Bias o Stale price bias: results in lower reported correlations o Backfill bias (inclusion bias): when missing past return date for component of index are filled at discretion of component when it joins the index—only components w/ good past results will be motivated to supply them  Investment Characteristics: o Common set of return drivers based on trading strategy factors (e.g., option-like payoffs) and location factors (e.g., payoffs from buy-and-hold policy) help explain returns of each strategy o Long-biased hedge funds are return enhancers rather than diversifiers o Hedge funds attempting to be least affected by market direction may be diversifiers  Role in portfolio: o Scrutinize managers o Emphasize style selection o Often have option characteristics that present challenge when relying on MVO o Mean-variance improvement o Lower skewness and higher kurtosis  Adopt mean-variance, skewness and kurtosis-aware approach to hedge fund selection  Invest in managed futures: tends to have skewness opposite many hedge funds  Other issues: o Young funds outperform old funds on a total-return basis, or at least old funds do not outperform young ones o On average, large funds underperform small funds o FOFs may provide closer approximation to return estimation than indices do o Performance fees and lock-up periods: some evidence of better performance of funds w/ quarterly lock-ups over monthly o FOFs: style drift: may time one market and have become less useful in asset allocation strategies o FOFs: don’t usually impose lock-up periods o Fund size: smaller more nimble and higher risk-adjusted returns; larger have more clout o Age (vintage) effects  Hedge Fund Due Diligence: o Structure o Strategy o Performance data o Risk o Research o Administration o Legal o References  Performance Evaluation: o
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