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5、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) style drift only. 

B) both survivorship bias and style drift.

C) survivorship bias only. 

D) neither style drift nor survivorship bias, and fund of funds do not serve as good indicators of aggregate hedge fund performances. 

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The correct answer is C

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.

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6、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 be more liquid. 

B) offers diversification. 

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

D) would have a lower correlation with equity markets. 

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The correct answer is D

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.

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7、Which of the following is an example of structural risk associated with hedge fund investments?

A) Operational risk.

B) Market risk.

C) Credit risk.

D) Liquidity risk.

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The correct answer is A

Structural risk focuses on risks stemming from a hedge fund’s operations and is therefore associated with operational risk. Market risk, credit risk, and liquidity risks, while important, are examples of strategy risks.

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8、In distinguishing between strategy risks and structural risks that stem from a fund of hedge funds, which of the following would be considered strategy risk(s)?

  I. Trading liquidity risk.

 II. The extent and form of management oversight.

III. The risk of poor information reporting systems.

IV. The risk of high ownership concentration of hedge fund shares.

A) I, III and IV. 

B) I only. 

C) II and III. 

D) II and IV. 

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The correct answer is B

Hedge funds face structural risks that stem from a hedge fund’s operations. These risks include the potential for deterioration in a firm’s reputation, poor information reporting systems, inadequate management oversight, etc. Strategy risks derive from a hedge fund’s investment strategy. They include a fund’s exposure to price swings from different asset classes (market risk), the risk of non-performance by counterparties (credit risk), the risk of price impact from executing large trades (trading liquidity risk), and the risk of not being able to meet interim cash flows obligations before strategies are able to become profitable (funding liquidity risk).

 

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AIM 2: Explain how funds of hedge funds can be classified according to diversification characteristics.

1、A risk reducer hedge fund is characterized by:

A) high returns and high positive correlation with traditional asset classes. 

B) low returns and low positive correlation with traditional asset classes.

C) high returns and negative correlation with traditional asset classes. 

D) low returns and negative correlation with traditional asset classes.

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The correct answer is B

A risk reducer hedge fund is characterized by lower returns, and low correlations with traditional stock/bond asset classes. One example is a long/short equity fund.