Chapter 26  Hedge Funds
CHAPTER 26: HEDGE FUNDS
PROBLEM SETS
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 ‘market
neutral’ 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.
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.
3.
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.
4.
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.
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Chapter 26  Hedge Funds
5.
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
6.
a.Since the hedge fund manager has a long position in the Waterworks stock, he
should sell six contracts, computed as follows:
6
1,500
$250
0.75
$3,000,000
=
×
×
contracts
b.
The standard deviation of the monthly return of the hedged portfolio is equal to the
standard deviation of the residuals, which is 6%. The standard deviation of the
residuals for the stock is the volatility that cannot be hedged away. For a market
neutral (zerobeta) position, this is also the total standard deviation.
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 Spring '10
 SMITH
 Standard Deviation, incentive fee

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