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| Would a market-neutral hedge fund be a good candidate for an investor's entire retirement portfolio? If not, would there be a role for the hedge fund in the overall portfolio of such an investor? |
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| 1. No, a market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio because such a fund is not a diversified portfolio. The term ‘market-neutral’ refers to a portfolio position with respect to a specified market inefficiency. However, there could be a role for a market-neutral hedge fund in the investor’s overall portfolio; the market-neutral hedge fund can be thought of as an approach for the investor to add alpha to a more passive investment position such as an index mutual fund. |
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| A fund manages a $1.2 billion equity portfolio with a beta of.6. of the S&P contract multiplier is $250 and the index is currently at $800, how many contracts should the fund sell to make its overall position market neutral? |
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| 2. # of contracts = 1,200,000,000 / (250 x 800) x .6 = 3,600 contracts |
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| A hedge fund charges an incentive fee of 20% of any investment returns above the T-bill rate, which currently is 2%. In the first year, the fund suffers a loss of 8%. What rate of return must it earn in the second year to be eligible for an incentive fee? |
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| 3. At the end of two years, the fund value must reach at least 104% of its base value. Since the value of the fund at the end of the first year is 92% of its base value, the fund must earn 13% during the second year. This is merely the IRR of a 92 investment over one year with a FV of 104. |
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| How might the incentive fee of a hedge fund affect the manager's proclivity to take on high-risk assets in the portfolio? |
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Definition
| 4. The incentive fee of a hedge fund is part of the hedge fund compensation structure; the incentive fee is typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return. Therefore, the incentive fee resembles the payoff to a call option, which is more valuable when volatility is higher. Consequently, the hedge fund portfolio manager is motivated to take on high-risk assets in the portfolio, thereby increasing volatility and the value of the incentive fee. |
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| Why is it harder to assess the performance of a hedge fund portfolio manager than that of a typical mutual fund manager? |
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5. There are a number of factors that make it harder to assess the performance of a hedge fund portfolio manager than a typical mutual fund manager. Some of these factors are:
• Hedge funds tend to invest in more illiquid assets so that an apparent alpha may be in fact simply compensation for illiquidity.
• Hedge funds’ valuation of less liquid assets is questionable.
• Survivorship bias and backfill bias result in hedge fund databases that report performance only for more successful hedge funds.
• Hedge funds typically have unstable risk characteristics making performance evaluation that depends on a consistent risk profile problematic.
• Tail events skew the distribution of hedge fund outcomes, making it difficult to obtain a representative sample of returns over relatively short periods of time. |
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| Is statistical arbitrage true arbitrage? Explain |
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| 6. No, statistical arbitrage is not true arbitrage because it does not involve establishing risk-free positions based on security mispricing. Statistical arbitrage is essentially a portfolio of risky bets. The hedge fund takes a large number of small positions based on apparent small, temporary market inefficiencies, relying on the probability that the expected return for the totality of these bets is positive. |
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A hedge fund with $1 billion of assets charges a management fee of 2% and an incentive fee of 20% of returns over a money market rate. Which currently is 5%. Calculate total fees, both in dollars and as a percent of assets under management, for portfolio returns of:
A: -5%
B: 0
C: 5%
D: 10% |
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| A hedge fund with net asset value of $62 per share currently has a high water mark of $66. Is the value of its incentive fee more or less than it would be if the high water mark were $67? |
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| 8. The incentive fee is typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return. However, if a fund has experienced losses in the past, then the fund may not be able to charge the incentive fee unless the fund exceeds its previous high water mark. The incentive fee is less valuable if the high-water mark is $67, rather than $66. With a high-water mark of $67, the net asset value of the fund must reach $67 before the hedge fund can assess the incentive fee. The high-water mark for a hedge fund is equivalent to the exercise price for a call option on an asset with a current market value equal to the net asset value of the fund. |
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