Hedge Funds

Question 1

!Consider the following statement: “Hedge funds generally outperform their benchmark”.Please comment on this statement. Hint: make use of (at least) the following keywords: unstable risk characteristics.

Answer 1

It is difficult evaluate hedge funds with traditional risk adjusted methods due to their unstable risk characteristics.

These methods such as the Sharpe ratio can be manipulated.

Furthermore, outperformance maybe due to hedge fund ability to investment in more illiquid investments or self-reporting bias.

Question 1

Why is it difficult to assess the performance of a hedge fund portfolio than that of a mutual fund?

Answer 1

The following reasons make it difficult to assess the performance of a hedge fund portfolio than that of a mutual fund:

1. Survivorship bias: databases report only the hedge funds that perform well.
2. Hedge funds have unstable risk characteristics, making the performance evaluation,
   that is based on a consistent risk profile, problematic
3. Return bias: only funds that do well report their performance, increasing overall
   returns
4. Hedge funds invest in more illiquid assets

Question 2

What is Convertible arbitrage?

Answer 2

Convertible arbitrage is hedged investing in convertible securities, typically going long in convertible bonds and short stock, to reduce the risk of stock you are exposed to.

Question 3

What is a Fund of funds?

Answer 3

A fund of funds is a fund wich allocates its cash to several other hedge funds to be managed. They are also called feeder funds.

Question 4

What is Statistical arbitrage?

Answer 4

Statistical arbitrage is the use of quantitative systems to uncover many perceived misalignments
in relative pricing and ensure profits by averaging over all of these small bets.

It often uses data-mining methods to uncover past patterns that form the basis for the investment positions.

Question 5

Is statistical arbitrage true arbitrage? Explain.

Answer 5

No, statistical arbitrage is not true arbitrage.

It is not the same as risk free arbitrage, because you still have the stock-specific risk

Statistical arbitrage is essentially a portfolio of risky bets. The hedge fund takes a large number of small positions based on temporary market inefficiencies, relying on the probability that the expected return of these bets is positive

Question 6

How might the incentive fee of a hedge fund affect the manager’s proclivity to take on high-risk
assets in the portfolio?

Answer 6

The incentive fee is typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return.

Therefore, the incentive fee resembles the payoff to a call option, which is more valuable when volatility is higher.

Consequently, the hedge fund portfolio manager is motivated to take on high-risk assets in the portfolio,thereby increasing volatility and the value of the incentive fee.