Discuss the objectives, legal structure, and fee structures typical of hedge funds, and describe the various classifications of hedge funds.
Structures and Classifications
The term “hedge fund” is an inaccurate description of the investment class because these funds may or may not employ hedging techniques.
Most hedge funds are organized so as to remain exempt from most securities regulations. Participation typically requires a large minimum investment and is limited to small numbers of qualified investors.
Typical arrangements pay the manager a base fee, usually around 1% of assets, plus an incentive fee proportional to profits.
Hedge funds organized under section 3(c) (7) of the Investment Company Act may not advertise, must limit the number of investors to 500, and may only accept “qualified” investors, as defined by the Act. Hedge funds investments are not subject to a maximum amount.
The various classifications of hedge funds are:
Market-neutral funds take long and short positions but attempt to offset them to hedge against market moves.
Long/short funds take both long and short positions but do not try to offset them.
Event-driven funds focus on unique market opportunities, not offsetting positions.
Global macro funds take directional and leveraged bets on global asset classes, equities, fixed-income, currencies, and commodities.
Hedge funds are usually classified by the media and hedge fund databases according to their:
A. past performance.
B. legal structure.
⇒ The answer is C. The past performance of a hedge fund and legal structure are typically not criteria used in classifying hedge funds. Hedge funds are usually classified by investment strategy, although the system is somewhat subjective and there is substantial overlap between categories.
The largest category of hedge funds in terms of asset size is:
A. market-neutral funds.
B. global macro funds.
C. long/short funds.
⇒ The answer is C. Long/short funds are considered to be the “traditional” type of hedge funds, and they represent the largest category of hedge funds.
Explain the benefits and drawbacks to fund of funds investing.
Benefits and Drawbacks
Fund of Funds investing involves creating a fund to both individuals and institutional investors, which in turn invests in hedge funds.
Benefits: The fund-of-funds manager has the expertise needed to evaluate and conduct due diligence on individual hedge funds. A fund of funds may have access to hedge funds that are closed to new investors.
One of the main advantages to investing in a fund of funds (FOF) is that FOF provides:
A. higher expected returns.
B. lower management fees.
C. improved diversification of assets.
The answer is C. FOF will actually have higher management fees because the FOF will charge a fee in addition to the fee charged by the hedge fund manager. FOF actually has lower expected returns because of increased diversification. FOF can diversify across many hedge funds strategies to decrease risk.
Discuss the leverage and unique risks of hedge funds.
Counterparty risk is the exposure to the creditworthiness of the broker-dealers that hedge funds transact with.
Settlement risk describes the risk that a counterparty, such as a broker-dealer, fails to deliver a security as agreed.
Pricing risk occurs when broker-dealers, in order to protect themselves, adopt extremely conservative pricing policies, which in turn requires hedge funds to post a greater margin.
liquidity decreases a hedge fund’s trading flexibility.
Short covering is the risk that they will have cover their shots and repurchase securities at a price higher than sold.
Margin calls means that a highly leveraged position can result in forced selling of assets, possibly at a loss.
Which of the following strategies is least likely to be used by a hedge fund to increase leverage?
A. Borrowing external funds
B. Pursuing arbitrage opportunities
C. Margin borrowing
The answer is B. Borrowing through a margin account and borrowing external funds are methods commonly used by hedge funds to increase leverage. Hedge funds are generally allowed to pursue arbitrage opportunities, which may or may not increase leverage.
Discuss the performance of hedge funds, the biases present in hedge fund performance measurement, and explain the effect of survivorship bias on the reported return and risk measures for a hedge fund database.
Hedge funds have been in existence since the early 1990s, long enough to compile meaningful data. There are several reliable indexes designed to track hedge funds. One of the primary reasons why performance data has biases is that submission is strictly voluntary, so managers tend to only submit impressive performance information.
Hedge funds have demonstrated a lower risk profile than equities when measured by standard deviation. The Sharpe ratio, which is a reward-to-risk ratio, has been higher for hedge funds than for equities. Hedge funds have historically outperformed the S&P 500.
The six most common biases present in hedge funds are:
“Cherry Picking” by managers
Incomplete historical data
Survival of the fittest
Fee structures and incentives
Survivorship bias exists because only the successful hedge funds submit performance data, thus overstating performance when the index is considered to be representative of the entire hedge fund population. Likewise, stable funds tend to succeed, while more volatile funds tend to go out of business, causing the database to tend to understate volatility for hedge funds as an asset class.
The fee structure of a hedge fund may lead to biases in performance data because:
A. fund managers have incentives to take big risks if past performance has been poor.
B. hedge fund managers are not required to disclose information regarding fee structures.
C. hedge fund managers charge higher fees than managers of traditional funds.
⇒ The answer is A. Hedge fund managers have the potential to earn more than managers of traditional funds, but this does not bias performance data. Hedge fund managers typically receive a modest base fee (1%) and then a large incentive fee based upon performance. If past performance has been poor, then fund managers feel they have “nothing to lose” and may invest more aggressively.
Survivorship bias is acute with hedge fund databases because hedge
A. funds experience higher volatility of returns than traditional investments.
B. funds are more highly leveraged than other asset classes.
C. fund managers often do not have to comply with performance presentation standards.
⇒ The answer is C. The main reason behind the survivorship bias problem in hedge fund reporting is that hedge funds are exempt from most SEC regulations, including performance presentation standards. This lack of standards leads to many inconsistencies in reporting that are not present in other asset classes.