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drifting, adversely affecting its asset allocation and diversification. While style analysis for traditional mutual funds is relatively straightforward, the analysis for hedge funds is complicated due to their dynamic and often complex nature. For the exam, know the reasons.for style drift and be familiar with the approaches for monitoring style drift.

AIM 82.1: Compare how investment style is assessed between hedge funds and traditional long-only investments.

The concept of investment style is addressed differently for traditional fund managers versus hedge fund managers.

First, traditional fund managers typically take long-only positions, with little or no leverage. In contrast, hedge fund managers often take long and short positions, and use substantial leverage.

Second, investment style for traditional fund managers can be ascertained by examining the portfolio holdings or the correlation of the portfolio returns with passive style indexes. In either case, the investment style for the traditional fund manager is revealed by the holdings within the portfolio. In contrast, because of their more dynamic and flexible nature (e.g., long/short, use of derivatives, and leverage), hedge fund style cannot be determined simply by examining holdings or correlations (or linear exposures) with indexes. Instead, traditional investment style analysis must be modified to identify the risk factors to which the hedge fund is exposed.

Third, due to the vast array of hedge fund investing strategies (i.e., investment approaches of specific managers), there are a greater number of specialized or niche hedge fund styles versus traditional fund styles. Moreover, most hedge fund strategies are unique and proprietary. Therefore, both the investment style and strategy of the hedge fund must be examined. However, because of the complexities of hedge fund styles and strategies, the number of representative asset classes that must be analyzed can be very large.

Style Drift

AIM 82.2: Define style drift in hedge funds, discuss approaches to monitor style drift, and explain why it is important for investors in hedge funds to closely and continuously monitor style drift.

AIM 82.3: Discuss why hedge fund managers may drift from their original styles.

The hedge fund manager attempts to exploit his specialized skill area to identify attractive risk-return profiles. The investment style chosen by the fund represents the specialized skill of the fund manager(s). Therefore, hedge fund style drift refers to the managers departure from his specialized skill area. Hedge fund style drift can occur in two ways:

1. Changes in the risk factor exposures of the fund, including changes in exposures to preexisting risk factors or the emergence of exposures to new risk factors outside the scope of the manager's investment strategy.

2. Changes in the overall risk of the fund, primarily through changes in leverage.

Importance of Style Drift Monitoring

The examination of hedge fund style drift is important for two reasons.

First, from the bottom-up perspective, unexpected style drift complicates the due diligence process, in which the investor attempts to understand the fund manager's investment style and abilities to properly execute his strategy. Therefore, style drift misleads the investor.

Second, from the top-down perspective, unexpected style drift can expose the portfolio to unanticipated risks, and may divert the portfolio from optimal asset allocation. Optimal asset allocation refers to the identification of optimal weightings across various competing investment styles. If a manager departs from his predetermined style, then the investor will unexpectedly overweight the new style of the manager at the expense of the old style. Therefore, style drift moves the investor's total portfolio risk-return profile away from the originally assumed profile and may adversely affect his portfolio asset allocation and diversification.

Reasons for style drift are numerous, including the following:

• Poor style market performance—fund managers are tempted to move from a poorly performing style to a perceived outperforming style.

• Excessive cash inflows—successful fund managers may attract more money than their style can sustain.

• Poor manager performance—fund managers who are currently underperforming their style benchmark (and style peers) are tempted to improve performance by changing style and/or by increasing risk.

• Recent losses (drawdowns)—fund managers recendy losing a substantial sum may attempt to retrieve the loss by changing style and/or by increasing risk.

• Personnel change—leadership changes in the fund may lead to changes in style and strategy.

• Regulatory change—changes in investment trading laws can necessitate changes in fund style and strategy.

Approaches for Monitoring and Detecting Style Drift

Monitoring risk factors. Risk and return are related to the values of the risk factors. Therefore, fund risk and return will change if the values of the risk factors change. In particular, changes in the value of risk factors (away from historical long-term averages) may precede a change in fund style.

Returns-based analysis. Traditional returns-based analysis refers to a correlation analysis performed over time of the fund, returns with the returns on predetermined asset class indexes. The extent of style drift can be measured by the extent of changes in the sensitivities of the fund's returns to asset class index returns. Significant changes are indicative of change in style and/or risk level of the fund.

Performance attribution. Performance attribution is done to identify the major sources of fund performance, both good and bad. For example, the fund return is broken down into its components such as the contribution of asset class exposure, regional exposure, and currency exposure. Performance attribution shows whether the contribution of each component to overall performance is consistent with the stated style of the fund. Moreover, performance attribution shows whether the fund's exposures to die various components are similar to those of other funds of identical style.

Peer group comparison. Regressions can be performed of the fund returns against the average returns of the appropriate peer group. A fund is maintaining its style if the R-squared of the regression is high. The intercept measures the alpha or incremental risk-adjusted performance of the fund versus the peer group average. Recall that poor performance of the fund manager relative to his peers often motivates the manager to alter his style. So, a negative alpha may be a good predictor of future style drift. The interpretation of the regression slope is important too. If the slope equals 1.0, then the fund has a risk level identical to the peer group average. Therefore, significant changes in beta reflect significant changes in risk. A difference in the slope from a value of 1 typically reflects a difference in leverage used by the fund relative to the peer group average. Note that peer group comparisons and returns-based analysis are complementary. Returns-based analysis examines the performance of a fund over time (a time series analysis), over various market conditions. The peer group analysis looks at a set of funds (a cross-sectional analysis) over the exact same market period;

Position analysis. The style consistency of the fund manager can be examined via a detailed analysis of the separate holdings of the fund (a.k.a. holdings-based analysis).

Communication with the fund manager. Fund managers are willing to communicate and explain their strategies and trades. Armed with this knowledge, the investor can make an informed decision on whether style consistency is being achieved by the manager.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

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