week 11

Question 1

HEDGE FUND

 Transparency

Answer 1

usually set up as limited Liability Partnerships and provide minimal disclosure of strategy and portfolio composition

Question 2

HEDGE FUND

Investors

Answer 2

No more than 100 “sophisticated” and wealthy investors

Question 3

MUTUAL FUND

Investors

Answer 3

Number is not limited

Question 4

MUTUAL FUND

Transparency

Answer 4

Regulations require public disclosure of strategy and portfolio composition

Question 5

HEDGE FUND

Investment strategies

Answer 5

effectively partake in any investment strategy

can act opportunistically and empowered to invest in a wide range of investments

 Often use shorting, leverage, options

Question 6

MUTUAL FUND

Investment strategies

Answer 6

Predictable, stable strategies, stated in prospectus

 Limited use of short selling leverage and use of derivatives is highly restricted

Question 7

HEDGE FUND

 Liquidity

Answer 7

Have lock-up periods, require advance redemption notices

Question 8

HEDGE FUND

Compensation structure:

Answer 8

Charge a Management fee between 1-2% of assets and an incentive fee of 20% of profits

Question 9

MUTUAL FUND

Compensation structure:

Answer 9

management Fees are usually a fixed percentage of assets, typically 0.5% to 1.5%

Question 10

MUTUAL FUND

Liquidity

Answer 10

Investments can be moved more easily into and out of a fund

Question 11

Hedge fund strategies

directional

Answer 11

 Bets that one sector or another will outperform

other sectors of the market

Question 12

Hedge fund strategies

non-directional

Answer 12

 Exploit temporary misalignments in in security valuations e.g. corp bonds are higher than treasury bonds, hedge fund would buy corporates and short sell treasury securities

 Buy one type of security and sell another

 Strives to be market neutral

Question 13

Hedge fund strategies

Statistical Arbitrage

Answer 13

Uses quantitative systems that seek out many temporary and modest misalignments in prices among securities

involves trading in hundreds of securities a day with short holding periods (minutes or less)

Question 14

Hedge fund strategies

Pairs trading

Answer 14

form of statistical arbitrage

Pair up similar companies whose returns are highly correlated but one is priced more aggressively

Question 15

Hedge fund strategies

statistical arbitrage is associated with Data Mining

Answer 15

sorting through large amounts of historal data to uncover systematic patterns in returns that can be exploited by traders

Question 16

Possible sources of superior performance of hedge funds

Answer 16

superior managers

Exposure to omitted risk factors with positive risk premiums

 Liquidity
Survivorship bias Changing factor loadings Tail events

Question 17

Liquidity and hedge fund performance

Answer 17

Hedge funds tend to hold more illiquid assets than other institutional investors

Unexpected declines in market liquidity are an important determinant of average hedge fund returns

Hedge funds report average returns in December that are substantially greater than their average returns in other months

 The December spike in returns is stronger for lower-liquidity funds, suggesting that illiquid assets are more generously valued in December

Question 18

Hedge fund performance

Backfill bias:

Answer 18

 Hedge funds report returns only if they choose to, and they may do so only when their prior performance is good

Question 19

Hedge fund performance

Survivorship bias

Answer 19

 unsuccessful funds cease operation and stop reporting returns and drop out of the database, leaving behidn only the successful funds

 Hedge fund attrition rates are more than double those for mutual funds

Question 20

hedge fund performance and changing factor loadings

Answer 20

Hedge funds are designed to be opportunistic and may frequently change their risk profiles (cf important assumption that portfolio manager manatains a stable risk profile over time)

 If risk is not constant, alphas will be biased in the standard linear index model

Question 21

tail events and hedge fund performance

Answer 21

Many hedge funds rack up fame through strategies that make money most of the time, but expose investors to rare but extreme losses

Question 22

Fee structure in hedge funds

High water mark

Answer 22

High water marks give managers an incentive to shut down poorly performing funds

 If a fund experiences losses, it may not be able to charge an incentive unless it recovers to its previous higher value

With deep losses, this may be too difficult so the fund closes

Question 23

Fee structure in Hedge funds

Funds of funds (feeder funds)

Answer 23

 Hedge funds that invest in one or more other funds, providing an opportunity to diversify across hedge funds

 Supposed to provide investors with ability to diveristy across funds and provide due diligence in screening funds for investment worthiness

Question 24

Fund of funds

hedge funds and fee structure

what do you need to pay?

Answer 24

Pay an incentive fee to each underlying fund that outperforms its benchmark even if the aggregate performance is poor

Diversification can hurt the investor in this case

Question 25

Fund of funds hedge funds and fee structure how should you spread risk

Answer 25

 Spread risk across several different funds, but operate with considerable leverage  If the various hedge funds in which these funds of funds invest have similar investment styles, diversification may be illusory

Question 26

Hedge fund strategies Pairs trading how can market neutral positoins be formed

Answer 26

by buying the relatively cheap firm and selling the expensive one.

Question 27

liquidity and hedge fund performance typical alpha

Answer 27

typical alpha exhibited by hedge funds may be interpreted as an equilibrium liquidity premium rather than a sign of stock-picking ability i.e. fair reward for providing liquidity to other investors

Question 28

liquidity and hedge fund performance serial correlation

Answer 28

is a symptom of illiquid assets

Question 29

liquidity and hedge fund performance serial correlation implications?

Answer 29

thsi suggestion of smoothed prices has 2 important implications 1. hedge funds are holding less liquid assets and their apparent alphas may be in fact liquidity premiums 2. risk-adjusted performance measures are upward bias b/c any smoothing in the estimates of porftofilio value will reduce total volatility (increasing sharpe ratio) as well as covariances and tehrefore betas with systematic factors (increasing risk-adjusted alphas)

Question 30

positive serial correlation

Answer 30

positive returns are followed by positive than by negative returns this is an indicator of less liquid markets b/c when prices are not available (since asset is not actively traded), the hedge fund estimates its value where firms smooth out their value estimates

Question 31

liquidity hedge fund performance Sadka's studies show?

Answer 31

exposure to unexpected declines in market liquidity are an important determinant of average hedge fund returns

Question 32

liquidity and hedge fund performance santa effect

Answer 32

Hedge funds report average returns in December that are substantially greater than their average returns in other months

Question 33

liquidity and hedge fund performance why may returns be difficult to interpret?

Answer 33

hedge fund takes adv of illquid markets to manipulate returns by purposely misvaluing illiquid assets

Question 34

Hedge fund performance changing factor loadings Perfect market timing result

Answer 34

perfect market timinig (who engages in no security selection but moves funds from T-Bills into market portfolio only when the market will outperform bills) ## Footnote results in a nonlinear characteristic line and hence greater sensitivity to the bull market

Question 35

Hedge fund performance changing factor loadings Funds that write options

Answer 35

have greater sensitivity to the market when it is falling than when it is rising  Nonlinear characteristic lines suggest many hedge funds are implicit option writers

Question 36

Fee structure in Hedge funds what is the typical hedge fund fee structure

Answer 36

management fee of 1% to 2% of assets plus an incentive fee equal to 20% of investment profits Incentive fees are effectively call options on portfolios with a strike price X = current portfolio value x (1+benchmark return) manager gets the fee is portolio rises sufficiently but nothing if it falls

Question 37

alike mutual funds, hedge funds

Answer 37

pool assets of several clients and manage the pooled assets on their behalf

Question 38

performance evaluation of hedge funds is complicated by

Answer 38

survivorship bias potential instability of risk attributes existence of liquidity premiums unreliable market valuations if infrequently traded assets esp difficult when the fund engages in option positions