manchester88

Which of the following most accurately describes the distribution of hedge fund returns? Hedge fund returns:

A) are lognormally distributed.

B) have fat tails in the distribution.

C) are normally distributed.

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Investors should be concerned about hedge fund risk because hedge fund returns have fat tails on the left hand side of their distribution. In other words, the probability of large losses is greater than that expected from a normal distribution. For this reason, it is imperative that investors evaluate a downside measure of risk, such as maximum drawdown and/or value at risk.

manchester88

The return distribution of a merger arbitrage strategy, in which the fund manager purchases the target company and shorts the acquiring company stock, is best described as:

A) normally distributed.

B) positively skewed.

C) highly kurtotic.

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The returns of many hedge fund strategies – including merger arbitrage trades – are not normally distributed; rather they are highly kurtotic and negatively skewed.

manchester88

Non-normality in hedge fund returns is most likely to cause performance to be:

A) underestimated.

B) zero.

C) overestimated.

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Non-normality of hedge fund returns necessitates consideration of higher order moments of the return distribution—specifically skewness and kurtosis. For most hedge funds, the return distribution is negatively skewed and highly kurtocic. These are undesirable qualities from the perspective of an investor. Ignoring these higher-order moments leads to overestimation of performance.

manchester88

An investor considering investing in a hedge fund, would be most likely motivated in pursuing replicating strategy, rather than investing in the hedge fund directly when the hedge fund:

A) has a long lockup period.

B) returns have a large alpha component.

C) strategies are clearly disclosed.

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Investors may be motivated to choose hedge fund replication strategies over actual investments in hedge funds when: (1) hedge fund managers are not earning a positive alpha, (2) investors feel that the fees paid to hedge fund managers are not justified, and (3) investors have objections to hedge funds’ lack of transparency or liquidity.

manchester88

A difficulty in applying traditional portfolio analysis to hedge funds is that hedge funds have:

A) high standard deviation.

B) correlations with other asset classes that are static.

C) non-normal return distribution.

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Traditional portfolio analysis calculates the most efficient portfolio using return, correlation and volatility of assets. However, it is difficult to apply traditional portfolio analysis to hedge funds because: (1) it is difficult to develop accurate expected returns, (2) hedge fund correlation, beta exposures, and volatility can change over time, and (3) standard deviation is not a complete measure of hedge fund risk due to higher moment risks such as skewness and kurtosis. This is due to non-normal distribution of hedge fund returns.

manchester88

The usual result of adding hedge funds to a portfolio of traditional (stocks and bonds) investments is a decrease in:

A) standard deviation.

B) Sharpe ratio.

C) skewness and kurtosis.

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The usual result of adding hedge funds to a portfolio of traditional investments is that: (1) standard deviation will decrease, (2) the Sharpe ratio will increase, and (3) higher-moment exposures such as skewness and kurtosis will increase.

manchester88

Compared to a single manager hedge fund, a fund of funds is most likely to have higher:

A) management and performance fees.

B) return performance.

C) standard deviation.

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Funds of funds generally have higher management and performance fees than single manager hedge funds because funds of funds generally apply a second layer of fees on top of those paid to the underlying fund managers. Fund of funds’ returns tend to be equal to average hedge fund index performance—before fund of funds’ second layer of fees are deducted. By investing in 15 or more single manager funds of various strategies (diversifying), funds of funds achieve lower standard deviation.

manchester88

Compared to a single manager hedge fund, a fund of funds is most likely to have higher:

A) longevity.

B) survivorship bias.

C) backfill bias.

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Funds of funds generally have lower mortality, lower survivorship bias, and lower backfill bias than single manager hedge funds.