Chapter 20  Hedge Funds
CHAPTER 20
HEDGE FUNDS
1.
No, a marketneutral hedge fund would not be a good candidate for an investor’s
entire retirement portfolio because such a fund is not a diversified portfolio.
The
term ‘marketneutral’ refers to a portfolio position with respect to a specified
market inefficiency.
However, there could be a role for a marketneutral hedge
fund in the investor’s overall portfolio; the marketneutral hedge fund can be
thought of as an approach for the investor to add alpha to a more passive
investment position such as an index mutual fund.
2.
# of contracts = 1,200,000,000 / (250 x 800) x .6 = 3,600 contracts
3.
At the end of two years, the fund value must reach at least 104% of its base value.
Since the value of the fund at the end of the first year is 92% of its base value, the
fund must earn 13% during the second year. This is merely the IRR of a 92
investment over one year with a FV of 104.
4.
The incentive fee of a hedge fund is part of the hedge fund compensation structure;
the incentive fee is typically equal to 20% of the hedge fund’s profits beyond a
particular benchmark rate of return.
Therefore, the incentive fee resembles the
payoff to a call option, which is more valuable when volatility is higher.
Consequently, the hedge fund portfolio manager is motivated to take on highrisk
assets in the portfolio, thereby increasing volatility and the value of the incentive
fee.
5.
There are a number of factors that make it harder to assess the performance of a
hedge fund portfolio manager than a typical mutual fund manager.
Some of these
factors are:
•
Hedge funds tend to invest in more illiquid assets so that an apparent alpha
may be in fact simply compensation for illiquidity.
•
Hedge funds’ valuation of less liquid assets is questionable.
•
Survivorship bias and backfill bias result in hedge fund databases that report
performance only for more successful hedge funds.
•
Hedge funds typically have unstable risk characteristics making
performance evaluation that depends on a consistent risk profile
problematic.
•
Tail events skew the distribution of hedge fund outcomes, making it difficult
to obtain a representative sample of returns over relatively short periods of
time.
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Chapter 20  Hedge Funds
6.
No, statistical arbitrage is not true arbitrage because it does not involve
establishing riskfree positions based on security mispricing.
Statistical arbitrage
is essentially a portfolio of risky bets.
The hedge fund takes a large number of
small positions based on apparent small, temporary market inefficiencies, relying
on the probability that the expected return for the totality of these bets is positive.
7.
Management fee = 0.02 × $1 billion = $20 million
Portfolio rate
of return (%)
Incentive fee
(%)
Incentive fee
($ million)
Total fee
($ million)
Total fee
(%)
a.
5
0
0
20
2
b.
0
0
0
20
2
c.
5
0
0
20
2
d.
10
20
10
30
3
8.
The incentive fee is typically equal to 20% of the hedge fund’s profits beyond a
particular benchmark rate of return.
However, if a fund has experienced losses
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 Spring '10
 SukwonThomasKim
 Management, incentive fee

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