# P1.T3.21.7. Hedge fund basics

#### Nicole Seaman

##### Director of FRM Operations
Staff member
Subscriber
Learning objectives: Calculate the return on a hedge fund investment and explain the incentive fee structure of a hedge fund, including the terms hurdle rate, high-water mark, and clawback. Describe various hedge fund strategies including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures, and identify the risks faced by hedge funds. Describe characteristics of mutual fund and hedge fund performance and explain the effect of measurement biases on performance measurement.

Questions:

21.7.1. A hedge fund has USD $100.0 million of investor's funds and it charges the traditional "2 and 20" fee schedule; i.e., 2.0% management fee plus a 20% performance fee. Consider the following three strategies: • Strategy A is a safe investment with certain profit of$4.0 million and therefore return of 4.0%
• Strategy B is a riskier strategy with a 50% chance of a $7.0 million (gross) profit and a 50% chance of zero profit; the expected return is +3.5%. • Strategy C is the most risky strategy with a 50% chance of a$18.0 million (gross) profit and a 50% chance of a -\$15.0 million loss; the expected return is +1.5%.
Which of the following is TRUE?

a. Strategy A offers the best expected return to the hedge fund, but the worst to the investors
b. Strategy B offers the best expected return to both the hedge fund and to the investors
c. Strategy C offers the best expected return to the hedge fund, but the worst to the investors

21.7.2. Four FRM candidates participate in a study group. They are learning about the different types of hedge funds. Each of the learners (Albert, Blake, Connie, and Denise) makes two statements, as follows:
• Albert refers to the Fundamental Law of Active Management, which holds that the information ratio equals the information coefficient multiplied by the square root of breadth, IR = IC * sqrt(breadth), and says that a Long-Short manager has greater maximum breadth (i.e., number of possible investment decisions per period) than a long-only manager. His second claim is that Dedicated Short managers tend to underperform during bull markets.
• Blake says that many distressed debt managers are experts in the bankruptcy process. Her second claim is that Fixed Income Arbitrage managers typically employ leverage.
• Connie says that Merger Arbitrage (aka, Risk Arb) managers specialize in trading on material, non-public information. Her second claim is that Global Macro managers tend to rely on anthropological analysis because they invest in emerging market sovereign debt.
• Denise says that a Managed Futures manager might employ a cost of carry (COC) model to compute theoretical commodity prices. Her second claim is that an appeal of several of the common hedge fund strategies is that they have low correlations with the overall market (and if they also have low volatilities, then they also have low betas).
Three of the candidates have made a correct statement, but one candidate's statement is incorrect. Who is the person whose assertions are INCORRECT?

a. Albert
b. Blake
c. Connie
d. Denise

21.7.3. Joe is a 29-year-old single male who prefers to invest in a fund because he has neither the time nor interest to spend researching and selecting individual stocks. His financial advisor Sally is experience in the following fund categories: closed- and open-end mutual funds, hedge funds, and index funds. When Sally asks for Joe's preferences, his only strongly felt opinion is that he prefers to avoid paying high expenses or fees (reading the financial news gives him the impression that he should seek low fees because fees are trending toward zero). Which of the following is she MOST LIKELY to recommend to Joe?

a. An index fund (or exchange-traded fund, ETF) to achieve diversification with low fees
b. An active closed-end mutual fund that trades below its net asset value (NAV) because it will outperform as it pulls to maturity
c. A fund of hedge funds (FOHF) in order to overcome the principal-agent problem and ensure alignment between Joe's interest and the managers
d. An open-end mutual fund that has beaten the market in the prior three consecutive years because mutual fund performance tends to be persistent

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