Chap 14 - Structure of the Hedge Fund Industry

Question 1

What are the Distinctive aspects of hedge funds ?

Answer 1

Distinctive aspects of hedge funds :

1) Privately structured
2) Performance fees
3) Use of levers
4) Investments in listed and unlisted securities and real assets
5) Actively trade derivatives, short positions and invest in structured products
6) Often hold relatively concentrated portfolios

Question 2

What are CAIA classification of hedge fund strategies ?

Answer 2

CAIA classification of hedge fund strategies:

A. Macro and Managed Futures
B. Event Driven
C. Relative value
D. Equity Hedge
E. Funds of hedge funds

Question 3

What is a Global Macro strategy for a hedge fund ?

Answer 3

A1. Global Macro :

• An investment strategy that seeks to profit from major market fluctuations caused
  by political or economic events.
  Example
• If a manager believes that the U.S. is headed for a recession, he or she may short
  stocks and futures contracts on major U.S. indices or the U.S. dollar.

Question 4

What is a Managed Futures strategy for a hedge fund ?

Answer 4

A2. Managed Futures :

• Active futures and forwards trading on physical commodities, financial assets
  and exchange rates.
  Example
• Analysis of past price trends to set up an automated trading strategy

Question 5

What is a Event Driven strategy for a hedge fund ?

Answer 5

B. Event Driven :

• An investment strategy that seeks to exploit price inefficiencies before or after a
  corporate event.
  Types of strategy
• Activist
• Merger Arbitration
• In distress
• Multi-Strategy

and

• Frequent small profits and big losses
• Off-balance sheet risk

Comparison :
* Similar to selling a put
* Similar to an insurance contract
* Similar to Short Volatility exposure
* Similar to credit risk

Question 6

What is a Relative value for a hedge fund ?

Answer 6

C. Relative value :

Strategy that seeks to exploit temporary differences in the prices of similar securities
Types of strategy
* Convertible arbitrage
* Volatility arbitrage
* Fixed income arbitrage
* Multi-strategy
Same comparisons as for Event-Driven strategies

Question 7

What is a Equity Hedge for a hedge fund ?

Answer 7

D. Equity Hedge :

Investment strategy exposed to equity market risk
Types of strategy
* Long-Short
* Market Neutral
* Short Bias

Question 8

How do you evaluate a hedge fund program ?

Answer 8

Program construction
* Return and risk targets
* Type of strategy(ies) selected
Parameters
* Parameters based on volatility, expected returns, types of instruments traded, leverage,
historical drawdown and other factors such as length of track record, periodic liquidity,
minimum investment level and assets under management.
Opportunistic investing
* Opportunistic investing is used to expand the universe of possible investments, rather
than to reduce risk or diversify traditional investments.

Question 9

What is a hedge fund indices ?

Answer 9

Hedge Funds Index :

Most strategies cannot be linked to a traditional benchmark
Usefulness
* Acting as a proxy for a hedge fund asset class
* Performance benchmark to judge fund success/failure

Question 10

What are some problems in index construction ?

Answer 10

Problems in index construction
* Treatment of fees - Management and performance fees
* Inclusion or exclusion of CTAs and Managed Futures
* Weightings by assets under management vs. equal weightings
* Size of the hedge fund universe
* Representativeness of the sample in the indices
* Strategy definitions and drift style
* Investability

Question 11

What was the first hedge fund ?

Answer 11

Thee term hedge fund originated with the first hedge fund, A.W. Jones & Co., which was established in 1949 and invested in both long and short equity positions.

Question 12

What are the three primary elements of hedge funds ?

Answer 12

A hedge fund is an investment pool or investment vehicle that (1) is privately organized in most jurisdictions; (2) usually offers performance-based fees to its managers; and (3) can usually apply leverage, invest in private securities, invest in real assets,
actively trade derivative instruments, establish short positions, invest in structured products, and generally hold relatively concentrated positions.

Question 13

What are the six major investment flexibilities used by hedge funds ?

Answer 13

1. Hedge fund strategies often invest in nonpublic, unlisted securities—that is, securities that have been issued to investors without the support of a prospectus and a public offering and that are not publicly traded.
2. Hedge funds often use leverage, at times very large amounts (sometimes 10 times their net asset base) . (Mutual funds can borrow up to 33% of Net asset base, hedge funds don’t have restriction on this)
3. Hedge funds often use derivative strategies much more predominantly than do traditional investment vehicles such as mutual funds.
4. Hedge funds take short positions in securities to increase return or reduce risk. The ability to take very large short positions in public securities is one of the key distinctions between hedge fund managers and traditional money managers.
5. Hedge funds sometimes trade in more esoteric or riskier underlying investments, such as those that are structured.
6. Hedge funds tend to be more actively managed than traditional investment vehicles, with more complex strategies and with more dynamic risk exposures than
   traditional funds, which are often constrained to generating performance that is
   linked to a benchmark.

Question 14

The greater restrictions on mutual funds facilitate the distribution of shares more broadly to the public, whereas the lesser restrictions on hedge funds are consistent
with limited distribution to the accredited investors or qualified purchasers whom regulators deem able to properly evaluate the risks inherent in the offering.

Answer 14

True

Question 15

What is an asymmetric incentive fees and are they legal ?

Answer 15

Asymmetric incentive fees, in which managers earn a portion of investment gains without compensating investors for investment losses, are generally prohibited for stock and bond funds offered as ’40 Act mutual funds in the United States.

Question 16

What is Optimal contracting ?

Answer 16

Optimal contracting between investors and hedge fund managers attempts to align the interests of both parties to the extent that the interests can be aligned cost-effectively, with marginal benefits that exceed marginal costs.

Question 17

What is Managerial coinvesting and it’s biggest downside ?

Answer 17

Managerial coinvesting is an agreement between fund managers and fund investors that the managers will invest their own money in the fund. The idea is that by having their own money in the fund, managers will work hard to generate high returns and control risk. However, the downside to managerial coinvesting
can be excessive conservatism by the hedge fund manager.

Question 18

Excessive conservatism is inappropriately high risk aversion by the manager, since the manager’s total income and total wealth may be highly sensitive to fund performance. Note that investors tend to be better diversified than managers, meaning they are less exposed to the
idiosyncratic risks of the fund in relation to their total wealth.

Answer 18

True

Question 19

What is a perverse incentive ?

Answer 19

A perverse incentive is an incentive that motivates the receiver of the incentive to work in opposition to the interests of the provider of the incentive. Specifically, the behavior of fund managers may become especially contrary to the interests of the investors depending on the relative values of the fund’s NAV and HWM.

Question 20

Kouwenberg and Ziemba suggest that
this perverse incentive is substantially reduced when the fund manager invests in the fund along with investors, especially when the investment exceeds 30% of the manager’s personal net worth, as the upside from additional incentive fees earned on risky investments is offset by the potential losses of the manager’s personal investment in
the fund.

Answer 20

True

Question 21

What is the annuity view of hedge fund fees ?

Answer 21

The annuity view of hedge fund fees represents the prospective stream
of cash flows from fees available to a hedge fund manager. The example assumes a standard 2% management fee and a 20% incentive fee that is distributed to the fund manager each year.

Question 22

What is a pure asset gatherer and a closet indexer ?

Answer 22

A pure asset gatherer is a manager focused primarily on increasing the AUM of the fund. A pure asset gatherer is likely to take very little risk in a portfolio and, like mutual fund managers, become a closet indexer.

A closet indexer is a manager who attempts to generate returns that mimic an index while claiming to be an active manager.

Question 23

The annuity view of hedge fund fees indicates the enormous fees available
to managers for being able to sustain long-term growth in assets. The option view of hedge fund fees indicates the enormous gains in single-period expected incentive fees that managers can generate by increasing the volatility of a fund’s assets.

What are some of the influences on the behavior of hedge fund managers from these theories ?

Answer 23

1. Managers May Take Fewer Risks after a Period of High Returns and Take More Risks after a Period of
   Negative Returns. (Common sense says that fund investors would prefer that risk-taking behavior be governed by analysis of market opportunities rather than by the effect of risk on the manager’s compensation.)
2. Managers May Modify the Time Series of Returns to Enhance Risk-Adjusted Performance or to Improve the Number of Profitable Months.

Question 24

What is the lock-in effect ?

Answer 24

The lock-in effect in this context refers
to the pressure exerted on managers to avoid further risks once high profitability and a high incentive fee have been achieved.

Question 25

What are managing returns/ massaging returns ?

Answer 25

The terms managing returns and massaging returns refer
to efforts by managers to alter reported investment returns toward preferred targets
through accounting decisions or investment changes.

Question 26

CAIA Classification of Hedge Fund Strategies
I. Macro and Managed Futures Funs
(A) Macro
(B) Managed Futures
II. Event-Driven Hedge Funds
(A) Activists
(B) Merger Arbitrage
(C) Distressed
(D) Event-Driven Multistrategy
III. Relative Value Hedge Funds
(A) Convertible Arbitrage
(B) Volatility Arbitrage
(C) Fixed-Income Arbitrage
(D) Relative Value Multistrategy
IV. Equity Hedge Funds
(A) Long/Short
(B) Market Neutral
(C) Short Selling
V. Funds of Hedge Funds

Question 27

What is a fund of funds ?

Answer 27

A fund of funds in this context is a hedge fund with underlying investments that are predominantly investments in other hedge
funds.

Question 28

What is a single-manager hedge fund (single hedge fund) ?

Answer 28

A single-manager hedge fund, or single hedge fund, has underlying investments that are not allocations to other hedge funds. A single hedge fund may be a multistrategy fund.

Question 29

What is a multistrategy fund ?

Answer 29

A multistrategy fund deploys its
underlying investments with a variety of strategies and sub-managers, much as a corporation would use its divisions. In a multistrategy fund, there is a single layer of fees, and the sub-managers are part of the same organization. The underlying components of a fund of funds are themselves hedge funds, with independently organized managers and a second layer of hedge fund fees to compensate the manager for activities relating to portfolio construction, monitoring, and oversight.

Question 30

What is a hedge fund program ?

Answer 30

A hedge fund program refers to the processes and procedures for the construction, monitoring, and maintenance of a portfolio of hedge funds. We begin by
providing an overview of available funds and strategies.

Question 31

What are the 3 advantages of observing the returns of funds of funds (FoFs) ?

Answer 31

A fund of funds (or fund of hedge funds) is a hedge fund that
has other hedge funds as its underlying investments.

(1) FoFs directly reflect the actual investment
experience of diversified investors in hedge funds, (2) the databases on FOFs have
fewer biases than those on individual hedge funds, and (3) the net performance of
FoFs is net of the costs of due diligence and portfolio construction from investing in
hedge funds. These costs, which are borne directly by investors who invest directly
in individual hedge funds, are not reflected in the returns of individual hedge funds.

Question 32

What are the four groupings of hedge fund strategies ?

Answer 32

(1) equity strategies, which
exhibit substantial market risk; (2) event-driven strategies, which seek to earn returns by taking on event risk, such as failed mergers, that other investors are not willing
or prepared to take, and relative value strategies, which seek to earn returns by taking risks regarding the convergence of values between securities; (3) absolute return
strategies, which seek to minimize market risk and total risk; and (4) diversified strategies, which seek to diversify across a number of different investment themes.

Question 33

Many financial transactions that contain event risk, such as merger arbitrage positions, can be viewed or described as writing options.

What is a Short volatility exposure ?

Answer 33

Short volatility exposure is any risk exposure that causes losses
when underlying asset return volatilities increase. Event risk and short volatility trading strategies tend to have short volatility exposures because they are negatively
exposed to event risk, and events cause market volatility.

Question 34

During stable or normal market conditions, a short volatility exposure makes a
profit through the collection of premiums as long as realized volatility is less than the
market’s anticipated volatility. But in rare cases, short volatility strategies incur a substantial loss when the unexpected happens and event-driven hedge funds experience
losses associated with the failure of the expected event. Losses occur when volatility
increases beyond expectations or when anticipated events do not materialize.

Answer 34

True

Question 35

Insurance Contract Another way to consider the risk of event-driven strategies is that it is similar to the risk incurred in the sale of an insurance contract. Insurers sell insurance policies and collect premiums. In return for collecting the insurance premium, they take on the risk of unfortunate economic events. If nothing happens, the insurance company gets to keep the insurance/option premium.

Answer 35

In summary, many types of hedge funds act like insurance companies or option writers: If there is a disastrous financial event, they bear the loss.This exposure is exacerbated to the extent that arbitrage funds apply leverage.

Question 36

What is an Off-Balance-sheet risk ?

Answer 36

Event risk is effectively an off-balance-sheet risk—that is, a risk exposure that is not explicitly reflected in the statement of financial positions.

Question 37

Relative value strategies are essentially short volatility strategies, much like event-driven hedge fund strategies ?

Answer 37

Yes

Question 38

What is a relative return product ?

Answer 38

A relative return product is an investment with returns that are substantially driven by broad market returns and that should therefore be evaluated on the basis of how the investment’s return compares
with broad market returns.

Question 39

Bernardo and Ledoit demonstrate that Sharpe ratios are misleading when
the distribution of returns is not normal, and Spurgin shows that fund managers can enhance their Sharpe ratios by selling off the potential return distribution’s upper end—for example, by entering a swap to pay the year’s highest monthly return and be compensated for the year’s lowest monthly return.

Question 40

Constructing an opportunistic portfolio of hedge funds depends on the constraints under which such a
program operates. For example, if an investor’s hedge fund program is not limited in scope or style, then diversification across a broad range of hedge fund styles will be appropriate. If, however, the hedge fund program is limited in scope to, for instance, expanding the equity investment opportunity set, then the choices will be less diversified across strategies.

Question 41

What is Headline risk ?

Answer 41

Headline risk is dispersion in economic value from events so important, unexpected, or controversial that
they are the center of major news stories.

Question 42

What is instant history bias / backfill bias ?

Answer 42

Instant history bias or backfill bias occurs when an index contains histories of returns that predate the entry date of the corresponding funds into a database.

Question 43

What is liquidation bias ?

Answer 43

liquidation bias, which occurs when an index disproportionately reflects the characteristics of funds that are not near liquidation. Frequently, hedge
fund managers go out of business, especially to shut down an unsuccessful hedge fund. When the return histories of these funds are excluded from a database or an
index, it causes survivorship bias.

Question 44

What is Participation bias ?

Answer 44

The flip side to liquidation bias is participation bias. Participation bias may occur for a successful hedge fund manager who closes a fund to new investors and stops reporting results because the fund no longer needs to attract new capital.

Question 45

What are the two problems that occur from Strategy definitions ?

Answer 45

Strategy definitions, the method of grouping similar funds, raise
two problems: (1) definitions of strategies can be very difficult for index providers to
establish and specify, and (2) some funds can be difficult to classify in the process of
applying the definition.

Question 46

In sum, there
is no established format for classifying hedge funds. Each index provider develops its
own scheme without concern for consistency with other hedge fund index providers,
and this makes comparisons between hedge fund indices difficult.

Question 47

What is style drift ?

Answer 47

Style drift is
a consistent movement through time in the primary style or strategy being implemented by a fund, especially a movement away from a previously identified style or strategy.

Question 48

What are Synthetic
hedge funds ?

Answer 48

Synthetic hedge funds attempt to mimic hedge fund returns using listed securities and mathematical models. These funds are designed to replicate the returns of successful hedge
fund strategies but at a lower cost to investors as a result of lower fees. Both of these trends further complicate the classification of hedge funds into strategy types.

Question 49

What is the investability of an index ?

Answer 49

The investability of an index is the extent to which market participants can invest to actually achieve the returns of the index. This issue is usually more of a problem for hedge fund indices than it is for their traditional investment counterparts. Indices of listed securities are generally investable through holding the same portfolio described in
the index.

Question 50

A related issue is whether hedge fund indices should be investable. The argument is that an investable index excludes hedge fund managers that are closed to new investors and therefore excludes a large section of the hedge fund universe.

Investable indices have generally underperformed noninvestable indices.