Handbook of Alternative Assets Ch 7 - Additional Hedge Fund Risks

Question 1

Define what process risk is from investing in hedge funds

Answer 1

Process risk refers to the lack of transparency in the investment process (i.e. ”black
box” computer algorithms) when investing in hedge funds

It is an idiosyncratic risk that can be diversified away by investing in a portfolio of
hedge fund managers

Question 2

Describe two ways to manage process risk when investing in hedge funds

Answer 2

Avoid investing in funds where one cannot understand the investment process

Obtain a better understanding of the structure of the fund’s computer algorithm
strategy (i.e. inputs/outputs of the algorithm)

Question 3

Describe some challenges the investor faces when a hedge fund refuses to disclose
details on its trading and portfolio positions

Answer 3

Difficult to validate the authenticity and attribution of the hedge fund manager’s
performance (i.e. was this month’s return due to stock selection, or market
timing)?

Investor cannot appropriately monitor and measure the risks of the hedge fund
manager

Investors cannot aggregate risks across their entire investment program to
understand the implications at the portfolio level
Ÿ For example, it will be difficult to verify whether the hedge fund managers in a
portfolio are making stock selections in the same economic sector, thereby resulting
in more concentrated risk (instead of diversification)

Question 4

List a few issues with using VaR for measuring the potential loss in a hedge fund

Answer 4

1. VaR’s may not be directly compared across different hedge fund managers, since
   the managers may use different confidence levels, time horizons, and measuring
   periods
2. VaR is not additive
3. VaR is typically calculated assuming returns are normally distributed; however,
   hedge fund returns are typically non-normal
4. VaR assumes that market outliers occur infrequently; however, in reality outlier
   events occur more frequently than predicted by a normal distribution of returns

Question 5

Describe three biases that may be present in a historical database of hedge fund
returns

Answer 5

Survivorship Bias: Only the returns of hedge funds that survived over the
measurement period are being tracked in the database; the returns of hedge
funds that failed may have stopped being tracked

Selection Bias: Hedge funds who have been performing strongly have an
incentive to publicly disclose their fund returns to a database in order to attract
new investors

Catastrophe Bias: A hedge fund that is performing poorly and may go out of
business has no incentive to continue to report its performance

Question 6

Describe performance measurement risk in hedge funds

Answer 6

This refers to relying on the Sharpe ratio to measure and compare the performance of
hedge funds

However, the Sharpe ratio is not the most appropriate financial metric for hedge
fund returns that typically do not have a normal distribution

For instance, many hedge funds use derivatives with nonlinear payoff structures
that can lead to misleading Sharpe ratio conclusions

Question 7

Describe short volatility risk in hedge funds

Answer 7

Many hedge fund strategies, such as corporate restructuring, resemble shorting a put
option

These strategies perform poorly when market volatility increases

This is an off-balance risk, because the balance sheet of a corporate restructuring
hedge fund manager would only show a series of long and short stock positions

This gives the misleading impression that the portfolio is low-risk from the
offsetting long and short positions that minimize exposure to the broad market

Question 8

What is Beta-Expansion risk in hedge funds?

Answer 8

This risk refers to the fact that for hedge funds that short securities, there is a greater
sensitivity of the portfolio to downward changes in the financial markets than upward
movements

Empirical evidence shows that the beta of a hedge fund’s returns is significantly
larger for down markets than upward market movements

Caused by the fact that hedge fund managers often short the same security,
resulting in a condition known as ”crowded shorts”

When a short position in a security becomes crowded, there is extra selling
pressure on that security