karoliukas

In distressed securities investing, a private equity fund that seeks to partner with the company in which the fund invests would most likely be called:

A) a vulture fund.

B) a high yield fund.

C) an orphan equity fund.

---

A “vulture fund” is a private equity fund that uses an “active” approach where the fund or investor acquires positions in the company, and the investment gives some measure of control. The investor can then influence and assist the company and then acquire more ownership in the process of any reorganization. By providing services and obtaining a strategic position, the investors create their own opportunity.

karoliukas

When evaluating the performance of a hedge fund that uses leverage, the convention is to:

A) not attempt to evaluate the fund because the existence of leverage makes such an assessment impossible.

B) use an optimization model to determine the weights on the book and debt values.

C) treat an asset as if it were fully paid to effectively “look through” the leverage.

---

The conventions for dealing with leverage is to treat an asset as if it were fully paid to effectively “look through” the leverage. When derivatives are included, the same principle of deleveraging is applied.

karoliukas

When evaluating hedge funds, special issues that complicate the process would include the fact(s) that:

A) benchmarks are absolute return in nature and do not address other goals such as the elimination of systematic risk.

B) benchmarks are designed to be both long and short in nature, but most hedge funds are long only.

C) many hedge funds are absolute return vehicles for which no benchmark exists, and they can use long/short strategies while most benchmarks are long only in nature.

---

These are two problems in defining and creating benchmarks. One method for addressing problems in defining and creating benchmarks is the use of single and multi-factor models. Thus, factor models do not pose a complication but offer a solution.

karoliukas

With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of:

A) no reason; fund of funds earn returns that are equal to those of individual hedge funds.

B) both the extra layer of fees and the higher liquidity offered.

C) the extra layer of fees only.

---

Fund of funds are usually considered good choices for individual investors because they offer diversification and usually more liquidity. One problem with fund of funds is that they usually have lower returns. This is a result from both the additional layer of fees and cash drag (resulting from a desire to have higher liquidity).

karoliukas

Style drift and survivorship bias are often mentioned in the analysis of hedge fund performance. Which of the following statements is most accurate? Fund of funds can serve as better indicators of aggregate hedge fund performance than hedge fund indices because they tend to have a lower level of:

A) both survivorship bias and style drift.

B) survivorship bias only.

C) style drift only.

---

A fund of funds may serve as a better indicator of aggregate performance of hedge funds (i.e., a better benchmark) because they suffer from less survivorship bias. If a fund of funds includes a fund that dissolves, the fund of funds includes the effect of that failure in the return of the fund of funds; however, an index may simply drop the failed fund. A fund of funds can suffer from style drift. This can produce problems in that the investor may not know what he/she is getting. Over time, managers may tilt their respective portfolios in different directions. It is not uncommon that two fund of funds who claim to be of the same style to have returns with a very low correlation.

karoliukas

William Jones, CFA, has a client who wants to invest in a hedge fund. Jones might recommend a fund of funds instead of a single fund for all of the following reasons EXCEPT a fund of funds:

A) would have a lower correlation with equity markets.

B) would be more liquid.

C) may serve as a better indicator of aggregate performance of hedge funds.

---

Fund of funds are usually considered good choices for individual investors because they offer diversification, usually offer more liquidity, and suffer from less survivorship bias thus they may serve as a better indicator of aggregate performance of hedge funds. One problem with fund of funds is that they are usually more correlated with equity markets than an individual fund, and this lowers their ability to diversify the overall portfolio.

karoliukas

Which of the following would be among the most common compensation structures for the manager of a hedge fund?

A) An assets-under-management fee of 1.5% and an incentive fee of 20% of the dollar return over the initial investment.

B) An assets-under-management fee of 20% and an incentive fee of 1.5% of the dollar return over the initial investment.

C) An assets-under-management fee of 1.5% and a lock-up fee of 20%.

---

The most common compensation structure of a hedge fund consists of an assets-under-management fee, or AUM fee, of about 1%-2% and an incentive fee of 20% of “profits”. The definition of profit should be spelled out in the terms of the investment. It could be dollar return over the initial investment, for example, or the dollar return above the initial investment increased by some hurdle rate.

karoliukas

With respect to the operations of a hedge fund, a high water mark is designed to:

A) prevent a manager from allowing the fund to become so large that it cannot be managed efficiently and/or use its selected style effectively.

B) prevent a manager from being paid twice for the same gains of the fund.

C) put a cap on the assets-under-management fee.

---

The high-water mark provision is designed to prevent payment to a manager twice for the same gains. If a fund goes from $100 to $120 in value and the manager earns an incentive fee for the $20 gain, and then the fund’s value goes down to $110 and back to $120, the manager will not earn a fee for the gain from $110 back to $120. $120 was a “high water mark.”

karoliukas

In the structure of a hedge fund, which of the following is least accurate concerning a lock-up period? A lock-up period:

A) establishes a minimum investment period for each investment.

B) establishes a cap on new investment.

C) establishes exit windows.

---

A lock-up period is a common provision in hedge funds. Lock-up periods limit withdrawals by requiring a minimum investment period, e.g., 1-3 years, and designating exit windows. The rationale is to prevent sudden withdrawals that could force the manager to have to unwind positions.

karoliukas

William Jones, CFA, has a client who wants to invest in a hedge fund that has the strategy of investing in equities and has among its goals the elimination of systematic risk. Jones has found two funds that he thinks are well run: the Marius Fund that uses an equity market neutral strategy and the Hera Fund that uses a hedged equity strategy. Given the client’s stated preferences, Jones should recommend:

A) either fund.

B) the Hera Fund only.

C) the Marius Fund only.

---

Equity market neutral is usually the attempt to exploit price discrepancies through long and short positions. This strategy also has the goal of the systematic risks canceling because of the long and short positions. Hedged equity strategies take long and short positions in under and overvalued securities, respectively, like equity market neutral strategies. The difference is that hedged equity strategies do not focus on balancing the positions to eliminate systematic risks.