Structure of the Hedge Fund Industry

Question 1

Distinguishing Features of Hedge Funds

Answer 1

1) Privately organized
2) Performance-based fee
3) Investment flexibility

Question 2

Flexabilities

Answer 2

1) Trading
2) Private
3) Real Assets
4) Derivative
5) Short Positions
6) Structured Products

Question 3

Consolidation

Answer 3

Increase in the proportion of a market represented by a relatively small number of participants

Question 4

High-Water Mark

Answer 4

Highest NAV of the fund on which an incentive fee has been paid.

Question 5

Incentive Fee Formula

Answer 5

(NAVafterfees-NAVbeginning){incentive fee/(1-incentive fee)

Question 6

Optimal Contracting

Answer 6

Attempts to align the interests of both parties to the extent that the interests can be aligned

Question 7

Marginal Coinvesting

Answer 7

Context is an agreement fund managers and fund investors that the managers will invest their own money.

Question 8

Excessive Conservatism

Answer 8

High risk aversion by the manager, since the manager’s total income and total wealth may be highly sensitive.

Question 9

Perverse Incentive

Answer 9

Motivates the receiver of the incentive to work in opposition to the interests of the provider of the incentive.

Question 10

Annuity View of Hedge Fund Fee

Answer 10

Represents the prospective stream of cash flows from fees available to a hedge fund manager.

Question 11

Option View of Incentive Fee

Answer 11

Represents the prospective stream of cash flows from fees available to a hedge fund manager

Question 12

Incentive fee option value

Answer 12

max(i(ENAV-BNAV),0

Question 13

At-the-money Incentive Fee Approximation

Answer 13

i40%NAV*STDEV

Question 14

Pure Asset Gatherer

Answer 14

Manager focused primarily on increasing the AUM of the fund

Question 15

Closet Indexer

Answer 15

Manager who attempts to generate returns that mimic an index while claiming to be an active manager

Question 16

Lock-in Effect

Answer 16

Pressure exerted on managers to avoid further risks once high profitability and a high incentive fee have been achieved.

Question 17

Managing Returns & Massaging Returns

Answer 17

Alter reported investment returns toward preferred targets through accounting decisions or investment changers

Question 18

Classification of Hedge Fund Strategies

Answer 18

Organized grouping and labeling of hedge fund strategies.

Question 19

Five Strategies

Answer 19

1) Macro and managed future
2) Event-driven
3) Relative Value
4) Equity
5) Fund of funds

Question 20

Fund of Funds (FOF)

Answer 20

Charges a fee for the due diligence it performs, and the funds within the FOF.
Double layer fee

Question 21

Single Manager Hedge Fund

Answer 21

Single hedge fund, underlying investments that are not allocations to other hedge funds.

Question 22

Multistrategy Fund

Answer 22

Deploys its underlying investments with a variety of strategies and submanagers, much as corporation would use its divisions.

Question 23

Fund Mortality

Answer 23

Liquidation or cessation of operations of funds, illustrates the risk of individual hedge funds and is an important issue in hedge fund analysis.

Question 24

Hedge Fund Program

Answer 24

Processes and procedures for the construction monitoring and maintenance of a portfolio of hedge funds.

Question 25

Equity Strategies

Answer 25

Substantial market risk

Question 26

Event-driven Strategies

Answer 26

Earn returns by taking on event risk, such as failed mergers, that other investors are not willing or prepared to take

Question 27

Relative Value Strategies

Answer 27

Seek to earn returns by taking risks regarding the convergence of values between securities.

Question 28

Diversified Strategies

Answer 28

Seek to diversify across a number of different investment themes.

Question 29

Convergent Strategies

Answer 29

Profit when relative spreads move tighter, meaning that two securities move toward relative values that are perceived to be more appropriate.

Question 30

Off-balance sheet risk

Answer 30

Risk exposure that is not explicitly reflected in the statement of financial positions

Question 31

Short volatility exposrue

Answer 31

Risk exposure that causes losses when underlying asset return volatilities increase.

Question 32

Relative Return Product

Answer 32

Investment with returns that are substantially driven by broad market returns and that should therefore be evaluated on the basis of how the investment’s return compares with broad market returns.

Question 33

Opportunistic

Answer 33

Major goal is to seek attractive returns through locating superior underlying investments.

Question 34

Headline Risk

Answer 34

Dispersion of economic value from events so important, unexpected, or controversial that hey are the center of major news stories.

Question 35

Fee Bias

Answer 35

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.

Question 36

Representativeness

Answer 36

Sample is the extent to which characteristics of that sample are similar to characteristics of the universe.

Question 37

Survivorship Bias

Answer 37

Index is constructed that disproportionately includes past returns of those investments that remain in operation

Question 38

Selection Bias

Answer 38

Occurs when an index disproportionately reflects characteristics of managers who chose to report their returns.

Question 39

Instant History Bias

Answer 39

Backfill bias occurs when an index contains histories of returns that predate the entry date of the corresponding funds into a database

Question 40

Liquidation Bias

Answer 40

Occurs when an index disproportionately reflects the characteristics of funds that are not near liquidation.

Question 41

Participation Bias

Answer 41

Successful hedge fund managers who closes a fund new investors and stops reporting results because the fund no longer needs to attract new capital

Question 42

Strategy Definitions Problem

Answer 42

1) Difficult for index providers to establish and specify

2) Difficult to classify in the process of applying the definition.

Question 43

Style Drift

Answer 43

Change through time of a fund’s investment strategy based on purposeful decisions by the fund manager

Question 44

Synthetic Hedge Funds

Answer 44

Attempts to mimic hedge fund returns using listed securities and math models

Question 45

Investability

Answer 45

Index is the extent to which market participants can invest to actually achieve the returns of the index

Question 46

Capacity

Answer 46

Limit on the quantity of capital that can be deployed without substantially diminished performance.