Theory Module 1 Flashcards
What are HF?
A HF is a private investment pool, open to institutional or wealthy investors, that is largely expect from SEC regulation and can pursue more speculative investment policies than mutual funds. Although funds follow very different strategies and have different risk and return profiles, the main idea is that sophisticated/wealthy investors need less protection (more buffer to absorb potential financial losses). Hedge fund strategies are focused on absolute returns (not relative to a benchmark).
Why is manager pay tied to performance and managers invest their own capital?
To align interest of managers with investor (minimize agency problems)
What is the aim for MF (active and passive)?
Active - outperform a benchmark; passive - track a benchmark.
Why is capacity limited for HF?
HF are trying to exploit arbitrage opportunities, so if the fund grows too big it has too much price impact to profit from those anomalies.
Why are HF fees large?
To cover transaction costs, but also management fees and research cost.
Why has there been a decline in the number of FoF?
Decline since 2008 due to poor performance, in turn due to their very high costs - there is a double layer of fees when investing in a FoF.
Why has the performance in recent years gone down relative to the performance in early years?
Markets have become more efficient, but also completion in HF industry has increased.
Why is the HF domicile important?
Because they can offer attractive tax and regulatory climates, which allows for increased flexibility in investment strategies, and tax benefits that accrue to the managers and the fund itself.
Why do institutional investors invest in HF?
Mainly for alpha generation and portfolio diversification (particularly important for pension funds, who assume that hedge funds have low correlations with other assets classes like fixed income).
What are the main reasons behind selecting a fund?
Past returns and the source of such returns (a.k.a the strategy).
What are the main concerns about hedge funds?
Crowding, Style drift, lack of liquidity, and lack of communication/transparency, macroeconomic factors.
What’s crowding?
A lot of funds are following very similar strategies and therefore holding very similar positions. If a lot of funds are holding the same assets these might become overpriced and therefore have lower returns.
Another drawback of crowding is that it might lead to an increase of risk: if a lot of funds have to exit a position at the same time there might be a fire sale, which lowers returns for the HF
What does the fee structure of HF look like?
It consists of two components: the management fee (depends on the size of the fund, usually 2%) and the incentive/performance fee (usually 20% of the gains above a so-called hurdle rate). This is a so-called 2/20 scheme.
How can an incentive fee be modeled?
It can be modeled as a call option, with the exercise price S0 being the value of the fund at the beginning of the year, times the hurdle rate.
What is a consequence of the asymmetric payoff structure of incentive fees?
Incentive fees are meant to align investors and managers interests, but due to the asymmetric payoff structure, HF managers may engage in excessive risk taking.
What’s a high water mark?
If the fund experiences losses, the incentive fee is paid only when the fund makes up for the losses. However, this creates an incentives to shut down fund after poor performance and simply start new fund.
What’s a fund of funds and what is the underlying idea?
FoF are hedge funds that invest in other hedge funds. The underlying idea is diversification benefits, provided that the underlying HF follow different strategies. They usually have a 1/10 fee scheme. They also pay incentive fees to the underlying HFs, creating fee-on-fee.
What does the Sharpe Ratio measure?
It measures the return compensation for unit of risk. It’s calculated as returns in excess of the risk free rate, divided by the standard deviation of such excess returns.
Why isn’t the Sharpe Ratio always an accurate measure of risk compensation?
Because hedge funds returns don’t follow a normal distribution and it’s not symmetric.
What’s value-at-risk?
It’s a measure of tail risk of an investment.
What does the high correlation between stock and hf returns signal?
It signals that diversification potential of hf is limited when added to an equity portfolio.
What happens to correlations during recessions?
They increase, meaning that diversification power decreases when it is most needed.
What is the alpha trend between 1990 and 2011? What’s the explanation (3)?
Downward trend over time. Following the initial success of hedge funds, many new hf were launched, so more arbitrage capital was being deployed. Increased competition, decreased transaction costs, and more readily available financial information, anomalies in the market have become smaller. This makes it hard for hf to find such anomalies and make a return.
Another potential explanation is the tightening of regulations and stronger emphasis on compliance after the financial crisis of 2008/09. This has constrained investor flexibility and may have lowered risk appetite of hf managers.
Another explanation is that the financial incentive for hf managers to work hard have decreased due to increase of AuM. In particular, incentive fee has declined in importance relative to management fee as fund size increases; in other words, since the size has grown so much, managers pocket substantial wealth fro the management fee alone.
What is a possible reason for increase in correlation of HF?
Growth of AuM. Because hf have grown, they can’t limit themselves to exploiting obscure anomalies, but have now positions also in stocks like Apple.
