Into to Hedge Funds

Question 1

What is a hedge fund?

Answer 1

• privately organized
• professionally managed
• pooled investment vehicle
• open to limited group of investors
• great flexibility in the type of assets it holds and positions it takes

Question 2

Why do regulators not consider a hedge fund to be a traditional investment vehicle?

Answer 2

Because the general public has no access to the private pool of capital.

Question 3

When does a hedge fund need to register with the SEC?

Answer 3

When it has more than 150M AUM

Question 4

AUM

Answer 4

Assets under management

Question 5

SEC

Answer 5

The Securities and Exchange Commission (SEC) is a U.S. government agency that oversees securities transactions, activities of financial professionals and mutual fund trading to prevent fraud and intentional deception.

Question 6

What returns does a hedge fund have?

Answer 6

Absolute returns. It doesn’t matter what happens in the market

Question 7

Incentive fees

Answer 7

• performance fees (20% of annual profits)

+ traditional management fees (1-2% of asset value)

Question 8

When is the performance fee not paid?

Answer 8

When the hurdle rate is not met or any previous losses are not recouped

Question 9

What must hedge fund managers do to align their interest with the fund?

Answer 9

Invest a large fraction of their personal wealth in the fund

Question 10

What allows hedge funds to invest in illiquid securities?

Answer 10

minimum investment periods and redemption notice periods (up to one-year)

Question 11

Instant History Bias or Backfill Bias

Answer 11

Instant history bias is a reporting inaccuracy that can inflate the performance of a fund or fund manager. Instant history bias can occur whenever a fund is given the option of when to join a database or index, as well as the option to backfill some of their historical returns. Given these two options, a fund can join at a high point and select a backfill period that includes the strongest results, creating an instant history within the database or index.

Question 12

HFR Lipper/TASS

Answer 12

Data Bases with quantitative performance data on Hedge funds.

Question 13

Returns smoothing

Answer 13

Returns smoothing enables a fund to hide risk. A substantial fraction of the funds trading very illiquid securities smooth their returns. These practices don’t in themselves represent a systemic risk for hedge funds – like in the LTCM crisis – because it represents only a very small fraction in terms of assets under management.

Question 14

Due diligence

Answer 14

When performing hedge fund due diligence, it is important to know everything that’s going on with the hedge fund and with the hedge fund management. Due diligence is about both quantitative and qualitative aspects of the hedge fund.

Thorough due diligence should be performed before an investor gets involved with any investment, especially hedge funds. The investor must also make sure that the hedge fund and the manager selected also comply with the legislation and the regulations set out by the financial services regulations board of the country in which the fund is based.

Question 15

The definition of a theoretical hedge fund

Answer 15

b= portfolio weights of the market benchmark
w = portfolio weights of a traditional actively managed portfolio
h = hedge fund weight
h= w-b

–> not possible because it is a net zero investment

Question 16

Alpha in terms of return

Answer 16

Alpha, one of the most commonly quoted indicators of investment performance, is defined as the excess return on an investment relative to the return on a benchmark index. For example, if you invest in a stock, and it returns 20% while the S&P 500 earned 5%, the alpha is 15. An alpha of -15 would indicate that the investment underperformed by 20%.

Question 17

Alpha in terms of risk

Answer 17

Alpha is also a measure of risk. In the above example, the -15 means the investment was far too risky given the return. An alpha of zero suggests that an investment has earned a return commensurate with the risk. Alpha of greater than zero means an investment outperformed.

Question 18

Alpha and Beta. How are they linked?

Answer 18

Alpha is one of the five major risk management indicators for mutual funds, stocks, and bonds and, in a sense, tells investors whether an asset has performed better or worse than its beta predicts.

Unlike alpha, which measures relative return, beta is the measure of relative volatility.

Question 19

Idiosyncratic risk

Answer 19

Idiosyncratic risk is a type of investment risk, uncertainties and potential problems that are endemic to an individual asset (like a particular company’s stock), or group of assets (like a particular sector’s stocks), or in some cases, a very specific asset class (like collateralized mortgage obligations). It is also referred to as a specific risk or unsystematic risk.

–> can be diversified away

Question 20

Does a hedge fund really hedge?

Answer 20

It hedges away risk not related to its speculative strategy. (There is still risk there)

In contrast for a traditional mutual fund, most of the risk comes from the benchmark ( and a minority from the active portfolio strategy)

Question 21

Risk of a hedge fund? Do we really know it?

Answer 21

Past performance may provide a very selective view of the risk of a hedge fund

Question 22

Which returns do mutual funds seek?

Answer 22

relative returns

Question 23

Is it possible to withdraw money at any time from a hedge fund?

Answer 23

No. Many funds have a lock-out period, which is an initial period of time during which investors cannot remove their money.