Introduction to Hedger Funds, Hedge Fund Returns and Asset Alloation

Question 1

What is safe harbor exemption of the Investments Act of 1940?

Answer 1

Exemption from filing, disclosure, record keeping and various reporting requirements mutual funds must adhere to.

Hedge funds fall within the safe harbor exemptions.

FDRR

Question 2

Who are considered wealthy individualas:

Who is an accredited investor

Who is a qualified purchaser in a hedge fund?

Answer 2

They are accredited investors and qualified purchasers.

Accreditor investor:

Investor has net worth > $1m, or annual income of $200k for each of last 2 years, $300k in the case of husband and wife.

Qualified Purchaser

Individual investor with net worth greater than $5m, Institutional investor with net worth greater than $25m

Question 3

Who are the primary investors in hedge funds?

Answer 3

1. Wealthy individuals,
2. pension funds,
3. foundations and
4. endowments

Question 4

What are the key elements that differentiate hedge funds from traditional investments?

Answer 4

They are differentiated by their Regulatory structures, Compenation Strctures and Trading Structures.

• Regulatory Structures; Privately organized and generally unlisted, hence not heavily regulated
• Compensation Structures: Offer managers performance-based fees
• Trading Structures: Invest in private securities, real estate, derivatives and strctured products. They use leverage, derivatives, short sell securities, and take concentrated positions

Question 5

What are the 5 calssifications of hedge fund strategies?

Answer 5

1. Futures Funds (Global Macro and Managed Futures)
2. Event Driven Hedge Funds
3. Relative Value (Arbitrage ) Hedge Funds
4. Long/ Short Equity Hedge Funds
5. Fund of Funds

The first 4 are single manager funds, 5th invest in a diverse group of single manager funds.

FE R(a) EF

Question 6

What are the 2 Hedge Fund fees

Answer 6

1. Management fees;
2. Carried Interest, Performance fees, Incentive fees or Profit -sharing fees

” 2 and 20” is the most common

Question 7

High water mark

Answer 7

Maximum previously observed NAV, Incentive may only be paid if the NAV is above the previous maiximum

Question 8

Hurdle Rate

Answer 8

Incentive fee will only be paid if the fund return exceeds a set threshold return (Net Return or Return net of management fee)

Question 9

What are techniques used to align inerests between managers and investors?

What is meant by the following?

• Excesssive conservatism;
• Perverse inventive
• assymetric incentive fee

Answer 9

O&M

Optimal contracting and managerial co-investing

• Excessive conservatism: Involves managers being extremely risk averse;
• Perverse incentive: Managers prusue more risky incentives;
• Asymetric incentive fees: Managers receive some investment gains without compensating investors for loss lkein the ‘40 Act mutual funds

Question 10

What are the 2 ways of viewing incentive fees, explain each

Answer 10

A O

• The annuity view demonstrates management’s incentive to earn large returns over a long period of time.
• The option view demonstrates how increasing the volatility will increase the present value of future management fees. Performance fees are considered a free call option (i.e. an incentive fee opton) granted to the fund manager on an annual basis. Increasing volatility increases the value of a call opton, this means that the manager is motivated to take too much risk.

Question 11

Pure Asset gatherers

Answer 11

Managers whose primary focus is to increase AUM. Their returns are highly correlated with index returns

Question 12

Closet indexers

Answer 12

They charge high management fees, but actually are passive investors

Question 13

What is meant by lock-in-effect?

Answer 13

Managers taking less risk when the NAV is far in the money, in line with the option view of hedge fund fees.

Question 14

What is the formula for incentive fee call option value?

Answer 14

i x 40% x (price of underlying asset) x sigma x square root of T.

Question 15

Why the long term growth rate of hedge funds?

Answer 15

Their favorable investment attributes viz.

1. Low correlation with traditional investments;
2. Ability of funds to hold both long and short positions;
3. Potential for large returns than what traditional investments provide.

Question 16

Higher kurtosis indicates

Answer 16

Leptokuritc (leap) distribution, fatter tail

Question 17

What are the 4 broad categories of hedge fund strategies?

Answer 17

1. Directional
2. Event risk
3. Absolute Return
4. Diversified

DEAD

Directional and Non-directional (Absolute) Return are the 2 major strategies

Question 18

Directional strategy

Answer 18

Any trading or investment strategy that entails taking a net long or short position in a market. It is betting on the direction the overall market is going to move in. A trader who is net long will benefit from a rise in the market.

Question 19

Event risk hedge fund strategy

Answer 19

Take position based on some event that has happened or is likely to happen

Question 20

Absolute Return Hedge Fund Strategy

Answer 20

Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing.

Absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. Hedge fund managers can use many different investment tools within an absolute-return strategy.

Question 21

Diversified strategy

Answer 21

Diversify across different investment themes

Question 22

What are the different hedger fund types?

Answer 22

1. Single manager funds, it does not contain other hedge funds.
2. Fund of Funds

When classified by trading strategies, CAIA classifies them into 5 groups, viz:

1. Macro and Managed Futures;
2. Evetn driven;
3. Relative value;
4. Equity
5. Funds of Funds

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Question 23

In relation to hedge fund indices:

1. Name the 3 well-known hedge fund databases
2. What is meant by Fee bias;
3. What is meant by the investability of an index;

Answer 23

1. TASS (Trading Advisor Selection Ssytem): HFR, CISDM (Centre for international Securities and Derivatives Market)
2. Fee bias: The returns that NEW investors are going to make are going to be lower than whar the index indicates;
3. Investability of an index is a measure of whether an investor can earn the same return as the index. If the index contains closed end funds, the investor cannot. Closed end funds constitute a large portion of the hedge funds universe.