Alternative Investments Management: November 2014

Modiﬁed Jones Model

Modified Jones Model

The so-called “modified Jones model” is a variation of the original Jones model (see Jones, 1991) proposed by Dechow et al. (1995) to separate nondiscretionary and discretionary accruals, which are used for earnings management purposes.

Like in the original Jones model, total accruals are regressed on a set of independent variables that are supposed to drive the extent of nondiscretionary accruals in the reporting period, thus letting the error term capture the unobservable extent of discretionary accruals. The only modification compared with the original model is that the change in revenues is adjusted for the change in receivables.

This adjustment is only made in the event period (where earnings management is supposed), and the original model is fitted in the other periods. The reasoning behind this adjustment is that, contrary to the assumption in the original model, managers indeed have discret ion over recognizing revenues, particularly when it comes to sales on credit.

Hence, changes in sales on credit are more likely to be manipulated and therefore drive rather discretionary than nondiscretionary accruals. However, the modification implies that all sales on credit in the event period are connected to the earnings management activities.

This is not a more convincing assumption than supposing that revenue recognition is not a subject to earnings management at all. It thus seems likely that the modified Jones model will overstate discretionary accruals (i.e., earnings management) when sales and receivables increase.

However, Dechow et al. (1995) provide evidence for the modified model, exhibiting more power in detecting earnings management than the original model. Like the original model, the modified model also was criticized for overestimating the level of discretionary accruals within periods of extreme financial performance.

Consequently, Kothari et al. (2005) empirically find that discretionary accruals estimations based on the original or the modified Jones model can be enhanced by performance matching. In the literature, various other modifications of the original Jones model have been discussed. However, distributional tests and rankings have more often been used than accruals models in recent research.

Mount Lucas Management Index

The Mount Lucas Management Index (MLM Index^TM) was created in 1988 by Mount Lucas Management Corp., headquartered in Princeton, New Jersey. The MLM Index^TM comprises three liquid futures contracts baskets (commodities, currencies, and global bonds) consisting of 22 futures contracts:

Commodities: copper, corn, crude oil, gold, heating oil, live cattle, natural gas, soybeans, sugar, unleaded gas, and wheat

Currencies: Australian Dollar, British Pound, Canadian Dollar, Euro, Swiss Franc, and Japanese Yen

Global Bonds: Canadian Government Bond, Euro Bund, Japanese Government Bond, U.K. Long Gilt, and U.S. Ten Year Notes

The three subportfolios are weighted by the relative historical volatility of each basket. Within each basket, the constituent markets are equally weighted. The MLM Index serves as a benchmark for evaluating returns from managed futures and is designed as a trend-following index. It compares the price of a future versus its 12-month moving average.

If the current price is above (below) its 12-month moving average, the index buys (sells) the futures contract. The index composition is rebalanced monthly and no leverage is employed. Mount Lucas Management Corp. replicates this index for a wide variety of investors via funds and separate accounts.

Multi-Manager Hedge Fund

A multi-manager hedge fund is an offering consisting of multiple fund managers. The offering may comprise managers within the same asset class or managers specializing in different markets and instruments. There are two main types of multi-manager funds: (1) fund-of-funds and (2) manager-of-managers. Fund supermarkets can also be considered as multi-manager products.

A fund-of-funds usually is structured as a limited partnership with the investment manager being responsible for performing asset allocation, manager due diligence, and manager monitoring.

A fund-of-funds can be dedicated—focused on one style, such as relative value, eventdriven, or even multi-strategy that focuses on a diversified exposure to several hedge fund categories. Hedge Fund Research (HFR), a Chicago-based index provider, has recently created a new database that groups fund-of-hedge funds by risk profile: conservative, diversified, market-defensive, and strategic.

Investing in a fund-of-funds provide several benefits. They offer instant diversification by investing in a number of funds and reducing idiosyncratic risk contributed by the individual funds. Studies of fund-of-funds demonstrate that a portfolio of five hedge funds can eliminate approximately 80% of the idiosyncratic risk of individual hedge fund managers.

Fund-of-funds facilitate access to hedge funds and for minimum investment of $1 million, investors can get access to a diversified portfolio of hedge funds that themselves usually have a $1 million investment minimum. Several fund-of-funds are listed on an exchange (e.g., Dublin, Frankfurt, London, and Zurich) and are members of clearing systems.

The familiar trading and settlement processes through an exchange, as well as the greater perceived oversight and transparency, offer some investors increased comfort with this type of product.

Fund-of-funds offer “professional management and built-in asset allocation”, as well as access to closed hedge funds. Further, they are able to get better transparency by virtue of the size of assets they invest in underlying managers, as well as confidentiality agreements that give them timely access to underlying positions.

Some of the disadvantages of fund-of-funds are the additional layer of fees, and possibility of duplication or overdiversification. Fund-of-funds usually charge a management fee, in addition to the fee of underlying hedge funds, of 1–2% on assets, and a performance fee of 10–20%.

Furthermore, they may hold of setting positions or the same position in the underlying funds, diminishing the investment return to the investor. Fund-of-funds may offer more liquidity than the underlying funds and should have a liquidity buffer to meet redemptions.

A manager-of-managers assembles and sometimes seeds specialists, offering them a common trading and risk platform. The manager monitors the specialists’ performance, engages in risk management at the aggregate level, and allocates risk capital depending on market opportunities and performance. A manager also can change the team in response to investor demand and market conditions.

A fund supermarket is a platform that offers multiple choices that have been prescreened but are not actively managed as a single offering and some even bundle funds by style or risk profile. Finally, investors have the advantage of some due diligence as well as obtaining their exposure through one supplier and receiving consolidated performance statements.

Multi-Strategy Fund

Hedge funds are loosely regulated investment funds that allow private investors to pool assets to be managed by an investment management firm. These funds are different from each other in their approaches and objectives, and hence they show varying levels of return and risk.

The strategy of a hedge fund can fall under several categories such as tactical trading, equity long/short, event-driven, and relative value arbitrage, with equity long/short strategies being the dominant strategy as of 2006.

An alternative to investing in a single-strategy hedge fund is the investment in a portfolio of hedge funds, a multi-strategy fund, to maximize return for a given level of risk. In this portfolio of hedge funds, called funds of hedge funds or funds of funds, an investor will have access to several managers and several investment strategies through a single investment.

A small drawback of investing in FOFs is the second layer of management and performance fees that compensate for the FOF manager’s expertise in identifying the best hedge fund managers for the portfolio. To diversify the portfolio risk, a funds of fund manager—a multi-strategy fund of funds—may allocate investment capital to several managers with different strategies.

In other words, a multi-strategy fund of funds incorporates various single strategies (not necessarily offered by the same organization) to diversify across strategies. A multi-strategy hedge fund can also be created by the various single-strategy hedge funds of ered within the same organization.

Through a multi-strategy fund, an investor can have higher returns and lower risk through strategy optimization (i.e., allocation of fund capital among strategies), can invest in hedge funds closed to new investors, can invest with a lower investment size, and can lower search/time cost of selecting the right manager/strategy at the cost of higher fees and possibly for moderate returns relative to a single-strategy fund.

Municipals Over Bonds Spread (MOB Spread)

The MOB spread, also known as the municipals over bonds spread, is the yield spread between municipal bond futures contracts and Treasury bond contracts with the same maturity. The spread is usually based on the bond futures contract closest to expiration, but with more than one month to expiration. The development of the MOB spread is driven by the relative development of the two underlyings: municipal bonds and Treasury bonds.

Treasury bonds are noncallable debt instruments issued by the federal government with a maturity of more than 10 years. they pay interest twice a year and pay back principal at maturity. Contrary to municipals, Treasury bonds are considered free of default. Thus, the differences in expected returns come from differences in maturity, liquidity, tax implications, and tax provisions.

Municipal (muni) bonds, on the other hand, are often callable, and have tax-free interest (however, this is not the case for capital gains). Muni bonds are issued by cities, counties, airport authorities, or other nonfederal political entities. Generally, they are either obligation bonds backed by the credit/taxing power of the issuer, or revenue bonds backed by the financed project or the respective operating municipal agency.

Because munis are tax-free, they sell at lower yields than nonmuni bonds with the same risk and maturity. Thus, in order to compare munis with Treasuries, we must first estimate a taxable equivalent yield by comparing the discounted cashflows before-tax and after-tax.

If the yield curve is flat and munis and Treasuries sell at par, the tax-equivalent yield can be approximated by dividing the muni yield by 1 minus the marginal tax rate. Consequently, changes in tax exemption rules will affect the performance of muni bonds relative to Treasury bonds, as well as the MOB spread.

Interest rate shit s may also af ect the MOB spread. For example, if interest rates fall, the muni bond issuer can call the bonds back and issue new ones at a lower interest rate. Thus the price of munis tends not to rise beyond a certain point.

On the other hand, the price of Treasury bonds will increase as interest rates fall, because they are noncallable. Consequently, the MOB spread will generally decrease as Treasuries outperform munis, and vice versa.

The sensitivity of the MOB spread to changes in interest rates depends on the makeup of the underlying index. This sensitivity increases with the time to maturity and the bond quality. Changes in the construction of the underlying will also result in changes in the MOB spread.

Betting on the spread is popular because it is relatively easy to predict. For example, it is easier to predict the relative development of changes in interest spreads because of consistent seasonal patterns of certain spreads. Predicting the general direction of interest rates is more dificult.

And demand for tax-free municipal debt relative to demand for Treasury debt is more predictable because of the state taxation system. thus, if a trader expects muni bonds to outperform Treasury bonds, he will buy muni bond futures contracts and short Treasury bonds.

National Introducing Brokers Association (NIBA)

The National Introducing Brokers Association (NIBA) was established as a not-forprofit association in 1991. It is a nationally recognized organization focused specifically on retail professionals in the futures and options business.

Membership is open to all introducing brokers, commodity trading advisors, futures and options exchanges, futures commission merchants, and other futures registrants, vendors, attorneys, accountants, and others having an interrelated interest in the futures industry.

The goals and objectives of NIBA are to make sure the channels of communication remain open to individual members and between introducing brokers, futures commission merchants, and industry regulators allowing members to do better business and find greater opportunities.

NIBA offers training to members through regular meetings and conferences. Meetings with the National Futures Association and the Commodity Futures Trading Commission are usually held on a regular basis to discuss regulatory/policy issues.

Membership permits right to use numerous privileges, as a number of vendors, suppliers, and resource providers to the industry offer reductions/ discounts to members of NIBA toward their products and services.

The futures commissions members are an indispensable part of the organization because they give the board of directors suggestions and clarifications on all aspects from industry alterations to company policy and offer association news to members via newsletters and electronic communication systems. NIBA’s main office is located in Chicago, Illinois.

Net Asset Value (NAV)

The net asset value (NAV) measures the difference between an entity’s asset value and the value of its liabilities. In terms of mutual funds and unit investment trusts (UITs), the NAV is usually calculated on a daily basis after the close of an exchange.

NAV is equal to the market value of securities and of other assets owned by a fund, net of all liabilities, and divided by the total number of outstanding shares. For example, if a fund owns assets of $100 million and has liabilities of $20 million, its NAV is equal to $80 million.

In closed-end mutual funds there could either be a discount (premium) to NAV if a fund’s market price is less (higher) than its NAV. This may be due to the investors’ expectations on future performances.

On occasions, mispricings may be persistent: this is the case of real estate mutual funds that cannot benefit from daily market prices to calculate their NAV. In terms of companies, NAV is usually used as a synonym for company’s book value and net worth.

The calculation of an investment company’s single share (i.e., the per share NAV) is usually calculated as total assets, less all liabilities and securities having a prior claim, divided by the number of outstanding shares. According to the above example, if we assume that the fund has 80 million shares outstanding, then the NAV per share is $1.

Net Long

Net long is a term used to describe when the value of an investor’s long portfolio surpasses that of the short portfolio. However, an investor can also be net long any number of items, such as an asset, market, portfolio, or a particular trading strategy.

An investor will take long positions in securities that they believe will increase in price over time and short positions in ones that will deliver negative returns. For example, a hedge fund that has 75% of portfolio weight in long equities and 25% in shorts is “50% net long.”

Ultimately this would result in directional exposure to equity market risk as the short portfolio would not be able to fully hedge the long portfolio. A short portfolio can act as a hedge against market declines as well as provide alpha.

More importantly, investors will vary the amount of net exposure as the market conditions change. For example, net long exposure of long/short equity hedge fund managers varied from very lofty levels in 1999 and 2000 during a period of soaring stock returns and to very low levels in 2002 when stock returns were down beat.

Nondirectional

Hedge funds strategies can broadly be characterized into directional and nondirectional ones. A directional strategy implies a bet anticipating a specific movement of a particular market, while a nondirectional strategy can be considered market-neutral. this means that nondirectional strategies have very little correlation with broad market indexes.

Many hedge funds employ nondirectional strategies by going long in certain instruments and simultaneously short in others with the result that net exposure to overall market movements (e.g., a stock index, style factors, industry factors, exchange rates, interest rates) is close to zero. Broad classes of nondirectional strategies are long/short, arbitrage and relative value, and event driven strategies (e.g., merger arbitrage).

Long/short strategies aim to identify undervalued and overvalued securities to set up a combined long and short position. long/short portfolios are rarely completely market-neutral and often exhibit either a short or a long bias.

Arbitrage and relative value strategies typically involve a perceived mispricing of related financial instruments. For example, convertible arbitrage involves a long position in convertible bonds combined with a short position in the underlying stock or bond.

While event-driven strategies are often categorized separately from market-neutral strategies, they typically involve little exposure to general market movements. The most popular event-driven strategies relate to investing in distressed securities and to merger arbitrage.

Notice Day

The day a clearinghouse can make a notice of intent to deliver stocks (commodities, indexes, etc.) to a buyer in fulfillment of (futures) contracts is defined as the notice day.

Additionally, we may mention that most initial public offerings (IPO) agreements include lockup provisions. these lockup provisions prohibit insiders from selling their shares for an agreed period (from 90 days to several years, usually 180 days) after the IPO.

The requirements for the sale of the pre-IPO shares are defined by SEC Rules 144, 144(k), and 701. Numerous empirical studies examine the impact of lockup expiration on the stock price behaviour.

Alternative Investments Management