Structure of the Hedge Fund Industry

Question 1

1. List the three primary elements that differentiate a hedge fund from other investment pools.

Answer 1

• A hedge fund is privately organized in most jurisdictions
• A hedge fund usually offers performance-based fees to its managers
• A hedge fund usually can apply leverage, use derivatives or utilize other investment flexibility

Question 2

2. Describe consolidation in the hedge fund industry in recent years.

Answer 2

• Consolidation in the hedge fund industry has been manifested in much higher percentages of assets being invested with the biggest funds. Institutional investors are showing a clear preference for the largest funds.

Question 3

3. Define high-water-mark in the context of hedge fund fee computation.

Answer 3

• The high-water mark (HWM) is the highest NAV of the fund on which an incentive fee has been paid.

Question 4

4. How can managerial co-investing contribute to optimal contracting?

Answer 4

• The idea is that by having their own money in the fund, through co-investing, managers will work hard to generate high returns and control risk, i.e. helping to align the interests of the hedge fund managers with that of the investors. Specifically, managerial co-investing may mitigate “gaming” emanating from large incentive fees.

Question 5

5. What is an example of a perverse incentive caused by incentive fees?

Answer 5

• If a fund experiences negative returns within a reporting period, the fund’s managers may view the fund as likely to close, in which case the managers may have a strong incentive to take excessive risks in an attempt to recoup losses and stay in business. Even if the managers do not fear that the fund will close, if the fund’s NAV falls substantially below its HWM, the managers may foresee no realistic chance of earning incentive fees in the near term unless the fund’s risk is increased. Thus, an incentive fee structure may encourage enormous and inappropriate risk taking by the managers.

Question 6

6. How does the annuity view of hedge fund fees differ from the option view of hedge fund fees?

Answer 6

• The annuity view of hedge fund fees represents the prospective stream of cash flows from fees available to a hedge fund manager through the long term.
• The option view of incentive fees uses option theory to demonstrate the ability of managers to increase the present value of their fees by increasing the volatility of the fund’s assets.

Question 7

7. What is the primary difference between a fund of finds and a multistrategy fund?

Answer 7

• In a multistrategy fund, there is a single layer of fees, and the submanagers are part of the same organization. The underlying components of a fund of funds are themselves hedge funds with independently organized managers and with a second layer of hedge fund fees to compensate the manager for activities relating to portfolio construction, monitoring, and oversight.

Question 8

8. Define short volatility exposure.

Answer 8

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

Question 9

9. When do convergent strategies generate profit?

Answer 9

• Convergent strategies profit when relative value spreads move tighter, meaning that two securities move toward relative values that are perceived to be more appropriate. This tends to be associate with calm markets rather than turbulent markets.

Question 10

10. What is fee bias?

Answer 10

• 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.