week 10 hedge funds

Question 1

Who started the first hedge fund and when?

Answer 1

Alfred Jones in 1949.

Question 2

What was Alfred Jones’s strategy?

Answer 2

Investing in stocks and hedging with short sales.

Question 3

How have hedge fund assets changed over time?

Answer 3

From under 4% of mutual fund assets in 1993 to 6.9% in 2021.

Question 4

Why are hedge funds important despite smaller AUM?

Answer 4

They account for nearly half of trading on major exchanges.

Question 5

What type of investment are hedge funds?

Answer 5

They are part of the ‘alternatives’ asset class.

Question 6

Key difference: regulation of mutual funds vs hedge funds?

Answer 6

Mutual funds are highly regulated; hedge funds are not.

Question 7

Who can invest in hedge funds?

Answer 7

Accredited investors only.

Question 8

Do hedge funds have to disclose holdings?

Answer 8

No, they are not required to provide transparency.

Question 9

Example of hedge fund secrecy risk?

Answer 9

LTCM in 1998, which collapsed due to hidden risks.

Question 10

What is an asymmetric incentive fee?

Answer 10

Fee is paid when fund performs well but not refunded when it underperforms.

Question 11

How are mutual fund incentive fees different?

Answer 11

They are symmetric and typically small.

Question 12

Can hedge funds use leverage and derivatives?

Answer 12

Yes, extensively.

Question 13

Do hedge funds allow easy redemption?

Answer 13

No, they often have lock-up periods.

Question 14

What is a typical hedge fund compensation structure?

Answer 14

1-2% management fee + 20% incentive fee.

Question 15

What is a high watermark?

Answer 15

Incentive fees are only paid on gains above previous peak NAV.

Question 16

What is a fund of funds?

Answer 16

A hedge fund that invests in other hedge funds.

Question 17

Downside of fund of funds?

Answer 17

Double fees and diluted returns.

Question 18

How do hedge funds add value to markets?

Answer 18

By exploiting inefficiencies and arbitrage opportunities.

Question 19

Why are hedge funds better at exploiting inefficiencies than mutual funds?

Answer 19

They can short-sell and use derivatives.

Question 20

Example of Equity Long/Short strategy?

Answer 20

Short DaimlerChrysler, long Ford — hedged against market/industry risk.

Question 21

Example of Fixed Income Arbitrage?

Answer 21

Short 30-yr bond, long 29.5-yr bond to exploit liquidity premium.

Question 22

What is downside beta?

Answer 22

Sensitivity of fund returns when the market is falling.

Question 23

What did Lo find about downside betas?

Answer 23

Downside betas often exceed upside betas.

Question 24

Hedge fund strategy compared to selling options?

Answer 24

Like selling out-of-the-money puts — profitable until large losses.

Question 25

Main challenges in measuring HF performance?

Answer 25

Short history, biases, risk adjustment, illiquidity, asset valuation.

Question 26

What is survivorship bias?

Answer 26

Excluding failed funds inflates average returns.

Question 27

What is backfill bias?

Answer 27

Funds report only after strong past performance, inflating reported returns.

Question 28

Why is risk adjustment hard for hedge funds?

Answer 28

Nonlinear strategies, use of derivatives, changing exposures.

Question 29

What is the illiquidity premium?

Answer 29

Extra return required for locking up money in illiquid investments.

Question 30

How might hedge funds misvalue assets?

Answer 30

Overstating illiquid assets in December to boost returns.

Question 31

What did Joenvaara et al. (2016) find about HF alpha?

Answer 31

4% annually (1994-2012), 2.89% (2004-12), not statistically significant.

Question 32

Is past HF performance persistent?

Answer 32

Yes — some performance persists across 3-year periods.

Question 33

Do hedge funds outperform mutual funds?

Answer 33

Slightly, but with higher risk and uncertainty.

Question 34

How do incentive fees act like call options?

Answer 34

Manager earns if fund value > benchmark, loses nothing otherwise.

Question 35

Current trend in fees?

Answer 35

Average management fee ~1.49%, incentive ~17.5%.

Question 36

Why might high watermarks lead to fund closures?

Answer 36

If underperforming, easier to restart a new fund.

Question 37

Critique of hedge fund diversification claims?

Answer 37

Many strategies offset each other; net effect is like the market.

Question 38

Are hedge funds truly a separate asset class?

Answer 38

No — they often trade the same securities as traditional funds.