Reading 34: Alternative Investm.... Management－LOS old t 2008

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CFA Institute Area 8-11, 13: Asset Valuation
Session 11: Alternative Investments for Portfolio Management
Reading 34: Alternative Investments Portfolio Management
LOS old t: Explain the rationale and importance of hedge fund incentive fees, and the concerns they may raise for hedge fund investors.

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Hedge fund managers with good track records:

A) usually lower their fees to increase the assets under management.

B) often demand higher incentive fees.

C) generally continue to have good track records.

D) do not exist.

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Answer and Explanation

Managers with good track records often demand higher incentive fees. The concern for investors is whether the manager with a good historical record can continue to perform well enough to justify the higher fees.

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If a hedge fund goal is the elimination of systematic risk, a problem for the fund in motivating the manager is that:

A) the standard incentive fee only applies to assets under management and would not reward the elimination of systematic risk.

B) it is impossible to gauge the degree to which systematic risk has been eliminated.

C) the standard incentive fee only applies to raw earnings and would not reward the elimination of systematic risk.

D) eliminating systematic risk is not a usual hedge fund strategy.

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Answer and Explanation

There is some controversy concerning fees because a manager may have or should have other goals than simply earning a gross return. For example, the manager may/should be providing limited downside risk and diversification. The basic incentive fee does not reward this service.

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For hedge funds, the basic incentive fee for managers may not be adequate because:

A) a manager usually earns a minimum incentive fee regardless of the performance of the fund.

B) they are usually too low, e.g., 2% or less.

C) a hedge fund manager may have several goals other than earning a high return, e.g., lowering downside risk.

D) there is no motivation to increase the size of the fund.

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Answer and Explanation

The rationale for incentive fees is obvious: encourage the manger to earn higher profits. There is some controversy concerning fees because a manager may have or should have other goals than simply earning a gross return. For example, the manager may/should be providing limited downside risk and diversification. The basic incentive fee does not reward this service.