Chapter 16 CAIA Flashcards - Structure of the Hedge Fund Industry

Question 1

Hedge Fund Definition

Answer 1

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 2

Safe Harbour

Answer 2

In investments, a safe harbor denotes an area that is explicitly protected by one set of regulations from another set of regulations.

Question 3

High Water Market

Answer 3

The high-water mark (HWM) is the highest NAV of the fund on which an incentive fee has been paid. Thus, the HWM is the highest NAV recorded on incentive fee computation dates but not necessarily the highest overall NAV.

Question 4

Optimal Contracting

Answer 4

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 5

Managerial Co-Investing

Answer 5

Managerial coinvesting in this context is an agreement between fund managers and fund investors that the managers will invest their own money in the fund.

Question 6

Excessive Conservatism

Answer 6

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.

Question 7

Perverse Incentive

Answer 7

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.

Question 8

Pure Asset Gatherer

Answer 8

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.

Question 9

Closet Indexer

Answer 9

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

Question 10

Managing Returns and Massaging Returns

Answer 10

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. Consistent with this hypothesis, Agarwal and colleagues find that December returns for hedge funds were higher than other months by 1.5% and that, after controlling for risk, residual returns continued to be 0.4% higher. The authors conclude that hedge funds may be managing, or massaging, their reported returns. However, they cannot explain why returns were unusually low between June and October of each year.

Question 11

Classification of Hedge fund Strategies

Answer 11

Macro and Managed Futures Funds

Event-Driven Hedge Funds

Relative Value Hedge Funds

Equity Hedge Funds

Funds of Hedge Funds

Question 12

Macro & Managed Futures

Answer 12

Macro

Managed Futures

Question 13

Event-Driven Hedge Funds

Answer 13

Activists

Merger Arbitrage

Distressed

Event Driven Multi Strategy

Question 14

Relative Value Hedge Funds

Answer 14

Convertible Arbitrage

Volatility Arbitrage

Fixed-Income Arbitrage

Relative Value Multistrategy

Question 15

Equity Hedge Funds

Answer 15

Long/Short

Market Neutral

Short Selling

Question 16

Short Volatility Exposure

Answer 16

Short volatility exposure is any risk exposure that causes losses when underlying asset return volatilities increase.

Question 17

Convergent Strategies

Answer 17

Convergent strategies profit when relative value spreads move tighter, meaning that two securities move toward relative values that are perceived to be more appropriate.

Question 18

Relative Return Product

Answer 18

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 19

Fee Bias

Answer 19

Fee bias is when index returns overstate what a new investor can obtain in the hedge fund marketplace because the fees used to estimate index returns are lower than the typical fees that a new investor would pay.

Question 20

Instant History Bias

Answer 20

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 and thereby cause the index to disproportionately reflect the characteristics of funds that are added to a database.

Question 21

Liquidation Bias

Answer 21

Liquidation Bias, which occurs when an index disproportionately reflects the characteristics of funds that are not near liquidation.

Question 22

Participation Bias

Answer 22

Participation bias may occur for a successful hedge fund manager who closes a fund and stops reporting results because the fund no longer needs to attract new capital.

Question 23

Synthetic Hedge Funds

Answer 23

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.