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Some hedge funds are designed to provide very high returns and may accept high degrees of risk to attain those returns

Answers to Questions

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1. To increase the return on a portfolio. Some hedge funds are designed to provide very high returns and may accept high degrees of risk to attain those returns.

2. To reduce risk. The average hedge fund is less risky that stocks. Even without the risk-reducing advantage of diversification, an asset allocation out of stocks and into hedge funds can lower portfolio risk.

3. To diversify returns. Diversification can reduce the risk of individual assets or asset categories. Because many hedge funds are not highly correlated with stock and bond returns, hedge funds can be very effective tools for improving portfolio diversification.

.2 Thousands of hedge funds exist. These funds follow a variety of strategies and assume different levels and types of risks. As a group, hedge funds have provided reasonable returns and have offered investors an attractive supplement to traditional stock and bond investments.

1.3 Relative return strategies are investment strategies designed to provide attractive returns relative to a benchmark. Most stock investing seeks to provide returns attractive relative to one or more equity index. Absolute return strategies are investment strategies designed to provide a pattern of returns that is substantially independent from stock and bond returns. As a consequence, success of the strategy should be evaluated without regard to how well typical benchmarks have performed.

1.4 To get the most risk reduction from diversification, low correlation is desirable. The funds with a correlation closest to zero are more effective diversifiers than funds with either a positive or a negative correlation. However, a high positive correlation to a particular strategy may be desirable. For example, if you want a convertible bond strategy,you would prefer a fund that is highly correlated to other convertible bond funds or an index of convertible bond hedge funds. Likewise, you would prefer a short equity fund with a correlation near -1.00 if the purpose of the investment is to hedge a long equity portfolio.

1.5 The size of the average hedge fund has also been increasing, so the

growth in assets has found its way into more hedge funds and allowed the size of hedge funds to rise.

1.6 It is possible that a fund could assess all the listed fees and incorporate

the listed fee designs and more. Hedge funds must declare the fees being assessed. Investors must trade off the level of fees against the return and risk of a hedge fund.

1.7 Private equity funds typically invest in investments that may have no

objective mark-to-market value. Because of the uncertainty about the monthly valuation, it is typical to assess no incentive fees until the return is actually realized.

.8 Many hedge funds register with the National Futures Association

(NFA) as commodity pools. Such hedge funds could plausibly be called commodity pools. However, the classification commodity

pool is commonly reserved for funds that use only commodities, futures, and options on futures.

1.10 A 4.5 percent return on a $100 million hedge fund earned $4.5 million. This is a nominal return so no adjustment for the amount of time is used. The gross return would be reduced by the management fee ($187,500). The incentive fee would be 15 percent of that amount

1.11 The hurdle rate of 5 percent is an annualized rate. The calculation uses a monthly rate of 5%/12. In practice, a hedge fund may adjust the annualized hurdle rate a number of different ways. In the following calculation, the incentive fee is assessed on only the amount that exceeds the hurdle return.

1.12 There will be no incentive fee until the fund has made back the 7 percent loss from January. If the fund was previously at a high-water mark, a return of 7.53 percent is required to regain that level. For example, if the NAV was $100 in January and fell 7 percent to $93, it is necessary to return 7.53 percent to return the fund NAV to $100. No incentive fee would be paid on returns until the fund attains a new high-water mark data is not generally published and individual returns are much less available than returns on stocks or bonds. Many index providers use the indexes as a marketing tool. Frequently, the same providers also sponsor funds of funds or collect some kind of sales charge for facilitating a hedge fund investment.

2.2 A long/short equity hedge fund may be long some stocks and short others. However, the size of the long position need not balance the size of the short position. These funds may be net long stocks (benefiting from rising stock prices) or net short stocks (benefiting from declining stock prices).

2.3 Despite the word hedge, many hedge funds make little or no attempt to hedge the risk of long positions with short positions. Equity arbitrage funds do create such hedges. These funds generally pursue fairly low-risk strategies and have lower returns than many other hedge fund styles.

2.4Pairs trading involves buying one class of security and selling anotherclass of security from the same issuer.

2.5 This hedge fund invests primarily in common stocks (long and short). The long and short positions are chosen to provide an attractive return and to offset market risk. Unlike a pairs trading strategy (discussed in Chapter 4), there may be no match of specific long positions to specific short positions.

2.6Merger arbitrage, spin-offs, divestitures, and bankruptcies are someevent driven strategies.

2.7 Convertible bond trading strategies are usually arbitrage strategies.

Most commonly, the fund buys a convertible bond or convertible preferred stock and hedges the risk to the underlying common stock. The fund may hedge interest rate risk, volatility risk, and financing risk to greater or lesser degrees. This strategy involves more leverage than most other hedge fund strategies.

2.8 A fixed income arbitrage hedge fund may buy bonds and sell fixed income futures or buy bonds denominated in a foreign currency with a currency hedge. Some fixed income arbitrage funds buy mortgages or mortgage derivatives and hedge the optionlike behavior of those instruments.

2.9 Emerging markets hedge funds may buy either stocks or bonds in a particular region or individual country. Generally, the funds have little opportunity to hedge currency exposure or market risk. Although the performance will be directional with respect to the individual securities market, this return may have low correlation to the securities markets of developed countries.

.10 Distressed securities hedge funds invest in low-rated or unrated bonds or equities of companies in or near bankruptcy. The largest risk involves that credit exposure: default, mark-to-market loss on downgrading, or assets inadequate to support debt repayment.

2.11 A global macro hedge fund primarily seeks a return by making a number of long and short investments in stock markets, bonds, and foreign currencies.

.12 A fund of funds is an investment company that invests in other investment companies which then invest in securities, futures, and derivatives. The label fund of funds is used to refer to funds of mutual funds or funds of hedge funds. The funds that invest in mutual funds are generally registered investment companies but the funds that invest in hedge funds are generally unregistered like the hedge funds they own.

2.16 Each of the hedge funds would lower the risk of the portfolio as measured by the standard deviation of return. However, a 10 percent investment in the convertible arbitrage strategy would result in lower volatility and lower returns. Probably the lower risk is sufficient to justify the lower expected return for most investors, but in this case, there are two choices that are unambiguously better than an all-stock portfolio. A 10 percent investment in the long/short strategy would provide the same expected return as an all-stock portfolio with less risk. The global macro strategy would raise the expected return and lower the risk. The portfolio containing the global macro strategy has a higher expected return than a portfolio containing the long/short portfolio and has less risk than the long/short portfolio. However, whether the investor prefers the portfolio containing the global macro strategy to the portfolio containing the convertible arbitrage fund would depend on investor preferences. Hedge fund investors measure risk in a variety of ways. The standard deviation of return is a popular choice, but other measures could yield different answers.

2.17 Even though the hedge fund has a lower expected return (8 percent versus expected returns of 10 percent for stocks) and is riskier (volatility of 20 percent versus 17.32 percent for stocks), it still makes sense to invest part of the portfolio in this fund to get the benefits of diversification. Following the logic in questions 2.13 through 2.16, you could analyze progressively higher investments in this fund larger investments in the hedge fund lower the risk of the portfolio until somewhere between 30 percent and 40 percent of the money is invested in the alternative (in this case, the portfolio has the lowest risk when 36 percent of the money is invested in the hedge fund strategy and 64 percent is retained in stocks). The expected return is also somewhat lower, so the investor must trade off the lower return versus the lower standard deviation of returns.

Many times, the alternatives are simpler. If the hedge fund can produce returns similar to the stock portfolio but provides good diversification (because it has a low correlation to stock returns), the blend of a hedge fund with stocks can produce the same or higher returns and lower risk.

2.18 The investor likely has risks that could be reduced by improving the

diversification in the portfolio. Unless the investor is willing to sell the closely held family company, any investment in a hedge fund would probably have to be funded by selling the market portfolio. The investor should study hedge funds that have weak correlations to the closely held asset, then design a portfolio to best diversify the risks of the rebalanced portfolio.

2.19 The direct investor avoids a layer of fees charged by the fund of funds.

The investor can also pick the portfolio of hedge funds that works best with other assets held by the investor. The investor may be able to demand information about positions held in the hedge funds and perhaps reduce some concentration of risks that might occur if the investor relies on others to select the managers.

2.20 A major part of the appeal of hedge funds is the way they perform differently from traditional portfolios. Investors seek out new and different ideas that may have low correlation to stock and bond returns and to other hedge fund returns.

2.21 The short-only hedge fund would act as a very powerful risk-reducing investment. However, if the investor has the ability to sell futures or buy put options, it would likely be possible to construct a cheaper hedge for the stock risk. The short fund manager selects issues likely to do worse than the market overall, so the short hedge fund may perform better in both rising and falling environments.

income arbitrage is one of the most leveraged strategies. Even if the position risk can be completely controlled, there are certain risks inherent to highly leveraged strategies including the loss of borrowing capacity and the inability to borrow issues sold short.

Institutions invest in hedge funds. Hedge funds can provide higher returns, better risk-adjusted returns, or returns uncorrelated with their existing portfolios. Taxable investors face unattractive tax consequences, so the advantages of hedge fund investing must outweigh this economic disadvantage. There is some effort to make hedge funds more tax efficient by funding them with IRA or 401(k) money or combining hedge fund investments with several insurance products.

3.2 The manager is careful so that none of the administration of the fund

is conducted within the United States. Although the fund may invest in U.S. assets, those assets are deemed to be owned outside the taxing jurisdiction of the IRS. However, if the fund pays a management fee to a U.S. manager, that income is taxable to the owners of the management company.

3.3 Probably not. Most countries tax their citizens and business units on investment returns regardless of where the returns occurred. Locating the hedge fund in a tax haven prevents the return from being taxed twice. Failure to report offshore income constitutes tax evasion in most countries.

3.4 Most hedge fund investments are motivated by the return and risk of the investment. In the absence of unusual circumstances, the offshore investor believes the U.S.-managed hedge fund will outperform funds created by managers in the investors home country. Frequently, the U.S. manager will locate the hedge fund outside of the United States so that the offshore investor isnt burdened with both U.S. taxation and tax at home.

3.5 Some hedge funds are riskier than stock investments but many are less risky than traditional assets. In addition, because the returns on many hedge funds do not closely track the returns of stocks and bonds, an institutional investor such as an endowment or foundation may be able to reduce portfolio risk through diversification. These institutions may be attracted to the prospect of very high returns along with high risk on a part of the portfolio. Finally, these institutions generally arent taxed on their investment returns so are less disadvantaged by the large amount of short-term gains that penalize high-net-worth individuals.

3.6 With a defined contribution plan, the individual workers are completely exposed to the investment returns on the contributions. If returns are large, benefits are larger. For the same reason, the pension beneficiaries are also exposed to the risk of loss. The plan sponsor and trustees should decide whether a hedge fund investment is appropriate for all the beneficiaries. The pension plan sponsor (often the employer) bears all of the investment risk with a defined benefit plan. There may be situations where a hedge fund investment is imprudent or barred by securities laws, but most plan sponsors are considered qualified investors.

3.7 It is generally regarded as acceptable for corporations to invest in hedge funds for short-term cash management, diversification of returns, or improved corporate profits. From the point of view of traditional financial theory, the corporation that invests in a hedge fund offers no advantage to its shareholders if the shareholders could invest parts of their portfolios directly in hedge funds. Management consultants could question why a corporation would invest time, effort, and capital in areas outside the primary expertise of the corporation. Finally, risk managers may question whether it is wise to expose funds devoted to a future capital project to the risk of loss.

3.8 Many investors value the diversification possible only in a fund of funds because they lack the resources to make multiple hedge fund investments. Many investors, including sophisticated institutional investors, are willing to delegate the fund selection to outside managers.

3.9 The language of the partnership agreement defines specifically how the management fee and incentive fees are applied. Because performance is provided monthly, it is reasonable to allocate 1/12 of the annual percent (2 percent divided by 12 or 0.167 percent per month).

The incentive fee is never negative (that is, the fund does not get paid 20 percent back on the losses), but most hedge funds do not charge incentive fees on the gains that make up prior losses. For example, the manager of fund B would charge no incentive fee in the second month, reflecting the loss. It would take a 4.43 percent return after the second month to offset the 4.24 percent loss, so the fund manager collects no incentive fee in the third month, because the value of the fund is still below the previous high-water mark. If the third-month return were more than 4.43 percent, the manager would charge no fee on the portion of the return in the third month that brings the investor back to the high-water mark achieved after the first month.

The fund manager of fund C charges no incentive fee in the first month. The return in the second month after management fee creates a new high-water mark before incentive fees of $103.42. The incentive fee on the $3.42 gain over the previous high-water mark of the net return for fund D simply reflects the 2 percent management fee and 20 percent incentive fee.

The returns are equally weighted in a fund of funds, implying that the fund of funds rebalanced at the end of each month. Alternatively, the fund of funds could have been constructed at the beginning of the period and the differences in performance would weight the winning funds (fund A and fund D) higher than the other funds.

The arithmetic average return after management fees and incentive fees imposed by the fund of funds manager is 0.91 percent. In Excel, use {= AVERAGE(1.20%, 1.02%, .53%)}. The geometric average return is 0.92 percent. To calculate the geometric average, simplify the following expression:

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Previous Issues

200605-23Hedge fund investments can be structured as notes that pay a coupon equal to the return of the underlying hedge fund assets

200605-22Hedge funds face very few restrictions on their use of derivatives in their portfolios

200605-21Marketing and Hedge Fund Regulations in the United States

200605-20Value at risk is an adaptation of classical statistics to risk measurement

200605-19Summary of Hedge Fund Risk and Return Data

200605-18Most hedge funds create an interim closing to measure partner gain or loss

200605-17Hedge funds located in taxable jurisdictions are structured

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