Nicole Seaman

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Learning objectives: Describe the characteristics of hedge funds and the hedge fund industry and compare hedge funds with mutual funds. Explain biases that are commonly found in databases of hedge funds ... Compare and contrast the different hedge fund strategies, describe their return characteristics, and describe the inherent risks of each strategy ... Describe the problem of risk sharing asymmetry between principals and agents in the hedge fund industry.

Questions:

21.13.1. You work as a pension fund administrator and the Investment Committee asks for your input. The pension fund seeks to increase its allocation to alternative investments and, in particular, will add a new hedge fund strategy; aka, style. You are limited to four strategies. You are perusing the brochures of four hedge funds (each named after Greek gods per a popular marketing convention!). The four strategies are global macro, merger arb, long/short equity, and equity market neutral.

Below are the four funds. Each fund has a name, a strategy (aka, style), a tagline, and a very brief description.
  • Acheilus is a Global Macro strategy. We are your effective asset (factor) allocator! We opportunistically make bets in different markets utilizing a range of strategies; you can think of us as betting on a range of factors such as commodities, interest rates, exchange rates.
  • Boreas is a Merger Arb (aka, Risk Arb) strategy. We collect nickels (and dimes) in front of the proverbial steamroller! Like our sibling event-driven strategy (i.e., Distressed), we can offer you nonlinear returns but with tail exposure to extreme market conditions.
  • Chimera is a Long/Short Equity strategy. We are friendly but will never hug a benchmark! Although we have some directional market exposure, we can be classified as relative value because we are stock pickers who seek alpha by way of a diversity of opinions and ability.
  • Daphne is an Equity Market Neutral strategy. We bring you a basket of betas! As an event-driven strategy, our returns are highly linked to several common market risk factors including equity indices, bond spreads, and volatility factors.
Each of these descriptions is consistent with its strategy (aka, style) category EXCEPT for one. Select the fund that is NOT consistent with its description.

a. Acheilus
b. Boreas
c. Chimera
d. Daphne


21.13.2. Hedge funds are less regulated than mutual funds. According to the authors (Fung and Hsieh), this lighter regulation of hedge funds offers genuine benefits but also creates unintended consequences. Which of the following is both a negative consequence and a TRUE statement about this relatively light regulation?

a. Lack of reliable, standardized, and long-term performance reporting
b. Lack of agreement on the specific definitions of absolute return and alpha
c. Ability of global macro funds to secretly drift into various strategies and styles with reckless impunity
d. Ability of hedge funds to advertise (and specifically solicit) to individual investors without any restrictions


21.13.3. Many critics of hedge funds say there exists a principal (investor) and agent (manager); they say it offers a classic example of the principal-agent problem with respect to asymmetry in risk sharing. The authors (Fung and Hsieh) claim that the principal-agent problem can be mitigated (i.e., significantly reduced if not almost eliminated) in several ways. According to them, each of the following can mitigate the principal-agent problem EXCEPT which is the LEAST LIKELY to mitigate (or reduce) the principal-agent problem in the hedge fund industry?

a. There is a high opportunity cost of closure
b. The managers have a large percentage of their own wealth invested
c. The fund has a traditional "2 and 20" fee structure and the loss-carried forward is currently large
d. The fund is large, old and closure would inflict reputational damage on the parent management company

Answers here:
 
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