5.1 Structure Of HF Industry

Question 1

First HF was found in and by?

Answer 1

by Alfred Winslow Jones in 1949. The A.W. Jones & Co. hedge fund took long and short positions in U.S. stocks with the intention of limiting market risk while focusing on stock selection.

Question 2

Growth of HF over the years?

Answer 2

1968, the number of hedge funds in the U.S. had increased to 140.

The bear market in the early 1970s witnessed the demise of many hedge funds and interest in the industry was not renewed until late 1980s.

The number of hedge funds grew considerably during the 1990s

2021, there were about 9,300 hedge funds with more than $4 trillion in total assets. In contrast, mutual funds and exchanged-traded funds had $30 trillion in total assets in 2021.

Question 3

3 primary elements of HF?

Answer 3

1) privately organized

2) manager performance based fees

3) investment flexibility

Question 4

Safe harbor

Answer 4

Exemption from certain disclosure regulations under US law

Question 5

6 differences of HFs?

Answer 5

i. Invest in nonpublic, unlisted securities. ii. Use significant leverage.
iii. Use derivative securities more often. iv. Short public securities.
v. Trade in riskier investments.
vi. More actively managed, with more complex strategies & dynamic risk
exposures.

Question 6

Reasons for HF growth? Latest growth figures?

Answer 6

• Reasons for growth -
1. Potential diversifiers (due to low correlations with traditional assets)
2. Investment flexibility (going long and short)
3. Potentially high, double-digit returns

Growth pre-2007; after financial crisis, consolidation (decline in AUM and
# of funds); 2009-2014: # of funds grew; 2015-2017 net attrition.

Question 7

Typical HF fees? Each fee detailed

Answer 7

Typically 1.6% management, 17.5% incentive

Management fee: 2% of AUM, charged periodically

Incentive fee: 20% of profits after management fee is deducted, charged annually

Question 8

High water mark (HWM) provision

Answer 8

A NAV above which the HF manager is compensated.

Every time the NAV expands, the new NAV is set as the benchmark

Question 9

Value of standard call option (HFs incentive fees) depend on 5 variables

Answer 9

1. Current value of underlying assets (the fund’s NAV)
2. Strike price (higher of the beginning-of-period NAV or HWM)
   •If there is a hurdle rate, the strike price is the future value of the NAV using the hurdle
   rate.
3. Time to maturity of the option (in this discussion, one year)
4. Risk-free rate (one-year risk-free bond yield)
5. Volatility of the underlying asset’s returns (standard deviation of the returns of the fund’s
   NAV)

Question 10

What is Option view of incentive fees?

Answer 10

Increasing fund’s volatility can increase PV of incentive fees.

Entitles manager to long European call on part of fund’s profits.

Incentive fee has option-like payout: manager shares upside of fund’s NAV; losses are limited

If profit generated, manager exercises in-the-$ call at year’s end and collects incentive fee; otherwise, out-of-the-S call expires worthless

> Incentive fee has maturity of one year

Manager pays no premium for option (just time and effort).

At maturity - Payout on incentive fee = Max [i (ENAV - BNAV), 0]

BNAV/HWM is strike price

Question 11

Incentive fee example:

HF with 20% incentive fee has $100m NAV and 9% annual return volatility.
What is the value of a one-year at-the-money incentive fee call option at start of year?

Answer 11

Question 12

Why are December returns for HFs higher? By how much?

(agardaw, daniel, naik)

Answer 12

Because of massaging or managing returns

By 1.5%

Question 13

Which funds are less likely to manage volatility?

Answer 13

Smaller & younger funds

Question 14

Single VS Multi manager HF?

Answer 14

Single: invests in securities / derivative instruments

Multi: different strategies / different sub managers

Question 15

HF classification

Answer 15

Question 16

HF Program

Answer 16

Process for construction, monitoring and maintaining portfolio of HFs

Question 17

HF Strategies by risk exposures

Answer 17

Question 18

Short bias funds

Answer 18

1) negative correlation (beta with equities = good risk reducers

2) lowest return of all HF strategies (zero average return)

3) positive alfa

Question 19

Event driven & relative value HF strategies key characteristics?

Answer 19

Consistently earn small profits, sometimes incur large losses

Lowest SD, large negative skew & excess kurtosis

Returns on this strategy are like selling insurance or puts

Question 20

Convergent strategies definition?

Answer 20

When prices of 2 securities converge and a return is made

Question 21

Short volatility exposures

Answer 21

Any risk exposures that result in losses if volatilities increase

Question 22

Absolute return strategies

Answer 22

Aim for consistently positive returns in any market conditions.

HF are absolute return products

Question 23

Relative return products (mutual funds)

Answer 23

Driven by broad market returns and evaluated relative to benchmark index

Question 24

Diversified funds returns?

Answer 24

High returns, reasonable risk, low drawdowns

Global & macro HF - generated returns close to normally distributed

In 2008, managed funds generated a profit and macro funds maintained their values

Question 25

What to consider in HF invest program

Answer 25

target leverage, return, risk

Question 26

HF Performance findings?

Answer 26

1. Shocks felt by one segment of industry reverberate to other strategies.
2. Historical HF returns may consistently overestimate future results, since growth in industry and effects on returns are not factored in.
3. Empirical data suffers from biases (e.g., selection or survivorship bias, which can inflate returns by 70bp to 450bp).

4) HF returns are not normally distributed

Question 27

Long only managers constraint

Answer 27

1) tracking error

2) long only - can short a stock up to its weight in the benchmark, thus underweighting a stock is constrained if it is only a small fraction of the index.

Question 28

Opportunistic HF Investing?

Answer 28

Good returns with aggressive positions in investments that offer short term superior ex ante alpha

Question 29

Headline risk

Answer 29

Change in economic value from unexpected news

Question 30

Reasons HF indices are useful benchmarks

Answer 30

1. Proxy for HF asset class (needed for asset allocation) - compare
2. Benchmarks of performance - among different managers

Question 31

How can fees affect reported returns?

Answer 31

1) frequency (paid annually, returns monthly)

2) fee bias (when hedge fund managers raise the fees they charge new investors, resulting in lower returns for the investors. Therefore, a hedge fund index’s historical returns will be overstated/higher relative to returns that new investors can earn.)

Question 32

Why is Size of HF universe is unknown?

Answer 32

1) little regulation

2) little overlap between index providers

3) high attrition rate (average life of manager 2.5-3yrs, mortality rate expected to increase)

Question 33

Database biases?

Answer 33

1) survivorship bias (2.6-5% per year)

2) selection bias
- managers voluntarily provide information
- high drop out rate after 14months

3) instant history / backfill bias (more of a problem for databases than published indices)
- 1-5% inflation of returns

4) liquidation bias (increases 0.7%)

Question 34

Reasons strategy definition can be problematic for an index

Answer 34

1. No standard for defining HFs strategies
2. No standard for classifying HFs
   • Classification by managers are often vague (what style or market is used?)
3. Style drift
   • Managers often stray from stated investment styles.

> Other issues: industry seen transition from single- to multi-strategy HFs, and synthetic hedge funds (which aim to replicate HF returns at lower fees) may become available.

Question 35

Investability of HF indices?

Answer 35

Investability of an index refers to whether market participants can hold a portfolio equivalent to the portfolio implied by the index and achieve the same returns. If an index contains closed funds, market participants cannot achieve the returns of the index.

Question 36

Which HF indices outperform?

Answer 36

Non investable indices outperform investable

Question 37

Hazard rate

Answer 37

% of funds that drop out of database at a given age (close)

Question 38

Which risk is off balance sheet?

Answer 38

Event risk

Question 39

Goal of HF investment program?

Answer 39

Risk management

Question 40

Incentive fee in terms of hedge funds?

Answer 40

Short position on European call option

Question 41

Main goal of opportunistic HF investment? How is it achieved?

Answer 41

Enhance returns of existing investment, can by accomplished by using best managers

Question 42

Short volatility strategy is similar to?

Answer 42

Selling a put option

Question 43

Participation bias?

Answer 43

Participation bias refers to the bias that arises when successful fund managers stop reporting their returns because they no longer need to advertise and attract new capital.

Average returns are likely to be understated by a hedge fund database if successful funds are omitted.

Question 44

The CAIA curriculum classifies market-neutral hedge funds as which strategy type?

Answer 44

Market-neutral hedge funds are equity funds (along with long/short and short selling funds).

Question 45

Is there a difference in cap weighted index and equally weighted?

Answer 45

No, cap-weighted and equally-weighted indices have similar correlations to equity and bond indices, which counters the argument that hedge fund indices should be cap-weighted because most asset lasses are benchmarked against cap-weighted indices (e.g., S&P 500).

Question 46

Annuity view of HF fees?

Answer 46

Manager earns large fees by consistently generating positive returns, attracting new investors, and staying in business as long as possible to continue earning fees on compounded returns and new capital.

Increasing volatility of the fund’s assets jeopardizes the longevity of the and may scare off potential new investors.

Question 47

Caveats with respect to using hedge fund performance data -

Answer 47

1. Different segments of the industry can be affected by the same market shocks.
2. Historical hedge fund returns may overstate future returns, since the growth in the industry has not been incorporated into the data; and this growth may result in lower returns due to increased competition, etc.
3. Biases (e.g., survivorship and selection) exist in hedge fund data, and these can inflate returns.

Question 48

The return generated by absolute return products is most likely attributable to?

Answer 48

Manager skill

Question 49

AUM of hedge fund industry in 2018 in the US

Answer 49

3.2+ trillion USD

Question 50

Some officials have accused hedge funds of playing a significant role in two major crises in currency markets in the 1990s.

Which most accurately identifies the crises and the evidence concerning the role of hedge funds?

Answer 50

1992 sterling devaluation and 1997 Asian contagion