5. Tracking Portfolio

5. Tracking Portfolio - the TP has a ß = 1.4 an α = 0 and...

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Index Models and Tracking Portfolios (and "key hedge fund idea") suppose we use a S&P 500 index model and find an underpriced portfolio (P): R P = 3% + 1.4R M + e P α = 3% believe in our model, so want to capture the α = 3%, but an R M < 0 can lead to a less profit and R M < 0 can lead to a loss strategy : construct a TP to match the systematic component of P's return • TP will track the market-sensitive component of P's return • TP must have the same ß as P and as little portfolio-specific risk as possible • TP will have a levered position in the S&P to get a ß = 1.4 the TP has 140% in the S&P and -40% in risk-free asset
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Unformatted text preview: the TP has a ß = 1.4, an α = 0 and e P = 0 ⇒ buy P and short TP ⇒ Ε ( Ρ ) = R P- R TP = 3% + e P ⇒ this position has no systematic risk but still has nonsystematic risk (e P ) • if P is well-diversified [such that e P > -3%], can take advantage of the positive α without being subject to market risk (exposure) • hedge fund aspect: identify an underpriced security and try to undertake a "pure play" on the security through a "long-short strategy" ⇒ hedge out all other risks, focusing the bet on the perceived α ⇒ construct a TP to hedge the risks that you do not want to be exposed to...
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