Alternative Investments 3

Question 1

What are hedge funds and who can invest in them?

Answer 1

Hedge funds are private pooled investment vehicles available online, generally only to qualified or accredited investors.

Question 2

In what asset classes do hedge funds typically invest?

Answer 2

Hedge funds invest in traditional asset classes like debt and equity, use leverage, and utilize derivatives to pursue their strategies.

Question 3

How do hedge funds compare to mutual funds, REITs, and ETFs?

Answer 3

Unlike mutual funds, REITs, and ETFs, which are publicly traded, hedge funds are privately held.

Question 4

How do hedge funds differ from private equity funds in terms of liquidity and time horizon?

Answer 4

Hedge funds invest mostly in liquid asset classes and have a shorter time horizon, with periodic redemptions, unlike private equity funds, which require a longer time horizon.

Question 5

Hedge Fund Strategies

Answer 5

1. Equity Hedge Fund Strategies
   - Fundamental Long/Short
   - Fundamental Growth
   - Fundamental Value
   - Market Neutral
   - Short Bias
2. Event-driven Strategies
   - Merger arbitrage
   - Distressed/Restructuring
   - Activist shareholder
   - Special Situations
3. Relative Value Strategies
   - Convertible Arbitrage Fixed Income
   - Speci fc fixed income (ABS/MBS/high yield)
   - General Fixed Income
   - Mulitstrategy
4. Opportunistic strategies
   - Macro strategies
   - Managed Futures

Question 6

Equity Hedge Fund Stratgies

Answer 6

seek to pro it from long or short positions in publicly traded equities and derivatives with equities as their underlying assets. Short positions taken to reduce or remove overall market risk can be in a market index if a manager does not have a negative opinion on speci fic securities. Subcategories include the following:
- Fundamental Long/Short
- Fundamental Growth
- Fundamental Value
- Market Neutral
- Short Bias

Question 7

Fundamental long/short.

Answer 7

Use long positions in undervalued securities based on fundamental analysis while simultaneously having a short position in a
portfolio of stocks or an index. This strategy seeks to capture alpha when a market correction occurs. Most managers have net long exposure (i.e., a long bias).

Question 8

Fundamental growth.

Answer 8

Use fundamental analysis to ind high-growth companies. Identify and buy equities of companies that are expected to sustain relatively high rates of capital appreciation, and short equities of companies expected to have low or no revenue growth. Typically, these funds have a net long bias.

Question 9

Fundamental value.

Answer 9

Buy equity shares that are believed to be undervalued, and short equities believed to be overvalued, based on fundamental analysis. The performance of value stocks relative to growth stocks drives performance.

Question 10

Market neutral.

Answer 10

Use technical or fundamental analysis to select undervalued equities to be held long and to select overvalued equities to be sold short, in approximately equal amounts to pro it from their relative price movements without exposure to market risk. Leverage may be used.

Question 11

Short bias

Answer 11

Employ technical, quantitative, and fundamental analysis and take predominantly short positions in overvalued equities, possibly with smaller long positions but with negative market exposure overall. This is a contrarian strategy that focuses on the manager’s skills at discerning lawed business strategies or accounting.

Question 12

Event Driven Strategies

Answer 12

are typically based on a corporate restructuring or acquisition that creates pro it opportunities for long or short positions in common equity, preferred equity, or debt of a specif ic corporation. Event-driven funds are typically long biased. Subcategories are as follows:
- Merger arbitrage
- Distressed/Restructuring
- Activist shareholder
- Special Situations

Question 13

Merger arbitrage

Answer 13

Buy the shares of a f irm being acquired and sell short the f irm making the acquisition. Although the term arbitrage is used, such a strategy is not risk free because deal terms may change or an announced merger may not take place.

Question 14

Distressed/restructuring.

Answer 14

Buy the securities of f irms in f inancial distress when analysis indicates that value will be increased by a successful restructuring, and possibly short overvalued securities at the same time.

Question 15

Activist shareholder.

Answer 15

Buy suff icient equity shares to inf luence a company’s policies, with the goal of increasing company value (e.g., by restructuring, change in strategy or management, or return of capital to equity holders).

Question 16

Special situations.

Answer 16

Invest in the securities of firms that are issuing or repurchasing securities, spinning off divisions, selling assets, or distributing capital.

Question 17

Relative value strategies

Answer 17

involve buying a security and selling short a related security, with the goal of pro iting when a perceived pricing discrepancy between the two is resolved. Subcategories include the following:
- Convertible Arbitrage Fixed Income
- Specifc fixed income (ABS/MBS/high yield)
- General Fixed Income
- Mulitstrategy

Question 18

Convertible arbitrage fixed income.

Answer 18

Exploit pricing discrepancies between convertible bonds and the common stock of the issuing companies and options on the common shares.

Question 19

Speci fic f ixed income (ABS/MBS/high yield).

Answer 19

Exploit pricing and quality discrepancies.

Question 20

General fixed income.

Answer 20

Exploit pricing discrepancies among f ixed-income securities of various issuers and types.

Question 21

Multistrategy.

Answer 21

Exploit pricing discrepancies among securities within and across asset classes and markets.

Question 22

Opportunistic strategies

Answer 22

focus on macro events and commodity trading. Often, these strategies are implemented using ETFs or derivatives in addition to individual securities. Subcategories include the following:
– Macro strategies
– Managed futures

Question 23

Macro strategies

Answer 23

Macro strategies are based on global economic trends and events and may involve long or short positions in equities, fixed income, currencies, or commodities. These funds bene it from heightened volatility surrounding major events. Smoothing of economic shocks by central bank actions reduce the attractiveness of these strategies.

Question 24

Managed futures

Answer 24

Managed futures funds may focus on trading commodity futures (these funds are known as commodity trading advisers, or CTAs) or incorporate f inancial futures. Commodity prices tend to behave differently than f inancial assets, in that high prices tend to decrease demand (which in turn decreases prices), while low prices reduce supply (which in turn increases prices).

Question 25

Unique Characteristics of Hedge Fund Investing

Answer 25

• less regulated and have flexible mandates, allowing them freedom to deploy a wide range of strategies, use leverage, and choose from a larger universe of securities and derivatives.
• higher cost, as they charge higher fees in the form of an incentive fee on top of generally high management fees.
• lower liquidity, including lockup periods and liquidity gates.
• often incur signif icant transactions costs when they redeem shares. Redemption fees can offset these costs. Notice periods and liquidity gates allow time for managers to reduce positions in an orderly manner. Redemptions often increase when hedge fund performance is poor over a period, and the costs of honoring redemptions may further decrease the value of the remaining partnership interests.
• There is reduced transparency about strategies followed and investments made by the fund to protect proprietary trading methods. This makes it diff icult for investors and analysts to assign accurate values to a hedge fund’s holdings.

Question 26

Lock Up period

Answer 26

the time after initial investment over which limited partners either cannot request redemptions or incur signi ficant fees for redemptions (a soft lockup)

Question 27

Notice Period

Answer 27

A notice period is the amount of time a fund has to fulf ill a redemption request made after the lockup period has passed.

Question 28

Liquidity gate

Answer 28

A liquidity gate is a partial restriction on redemptions (i.e., less than a full suspension of them).

Question 29

Investment Forms

Answer 29

Hedge funds can be structured as commingled funds, whereby capital from many investors is pooled together, or as a separately managed account (SMA) for a single large investor.

Question 30

Master-Feeder Structure

Answer 30

Commingled funds often have a master-feeder structure that is designed to be tax ef ficient, enjoys economies of scale, and allows for funding from global investors.
Under such a structure, there are two feeder funds: offshore (in a tax haven) and onshore. Both funds flow into a master fund, which makes the investments. The master-feeder structure bypasses regional regulatory requirements.

Question 31

SMAs

Answer 31

SMAs allow for a customized portfolio to meet an investor’s risk/return objectives. One concern is that the manager has no stake in the fund, so the manager’s interests are not as well aligned with those of the investor as they would be in a typical commingled fund. SMAs also require more operational oversight and thus are appropriate for larger or institutional investors. The benef it of lower negotiated fees in SMA structure is offset by the disadvantage of receiving allocations of only the fund manager’s most liquid trades.

Question 32

Structure

Answer 32

Hedge funds are typically structured as limited partnerships or limited liability corporations. The general partner is the fund manager and receives compensation based on the fund’s performance. The contractual relationships between the GP and LPs are laid out in the fund documents: partnership agreement, private placement memorandum, or articles of incorporation. Typically, a fund is structured to have an inde finite life, though most funds do wind down as they are liquidated on a regular basis.

Question 33

Fund-of-Funds

Answer 33

• A fund-of-funds is an investment company that invests in hedge funds.
• Fund-of- funds investing can give investors diversi fication among hedge fund strategies, offer a manager’s expertise in selecting individual hedge funds, and provide smaller investors with access to hedge funds in which they may not be able to invest directly.
• These funds also have reduced lockup periods and greater exit liquidity.
• Fund-of-funds managers charge an additional layer of fees beyond the fees charged by the individual hedge funds in the portfolio, however, they can signif icantly reduce investors’ net returns.

Question 34

Sources of Hedge Fund Returns

Answer 34

1. Market beta. This is the return attributable to the broad market index. Investors can get this from passive investments in index funds.
2. Strategy beta. This is the return attributable to speci ic sectors in which a fund has exposure.
3. Alpha. This is the additional return that is delivered by the manager through security selection.

Hedge fund managers use leverage to magnify the value added through strategy beta and alpha. High fees, however, act as a drag on performance.

Question 35

Survivorship Bias

Answer 35

Index returns may exhibit survivorship bias because hedge funds might not be included until they have existed for a minimum time or reached a minimum size. In this case an index will not ref lect the poor performance of funds that fail before reaching these minimums.

Question 36

Selection bias

Answer 36

Selection bias may result from index providers assigning funds to categories inconsistently or having different requirements for including a fund.

Question 37

Backf ill bias

Answer 37

Backf ill bias refers to the effect on historical index returns of adding fund returns for prior years to index returns when a fund is added to an index. Like selection bias, this tends to overstate performance because funds with better historical returns are more likely to be added.

Question 38

Hedge funds use leverage to magnify

Answer 38

alpha

Question 39

Hedge funds seek to reduce risks and often remove market beta exposure with

Answer 39

short positions