Download CSC FAQs - Module 21: Hedge Funds

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1. The managers of the HiBar hedge fund use a system to make all of the trading
decisions for the fund. They believe their systematic approach to trading, based on their
own technical and statistical analysis of price and volume information, is an effective
strategy. Which of the following types of hedge funds is the HiBar hedge fund most
A.
Fixed-income arbitrage
B.
Emerging markets fund
C.
Managed futures fund
100% Student Response
D.
Dedicated short bias
General Feedback: A managed futures fund invests in listed financial and commodity
futures markets and currency markets around the world. Fund managers are usually
called Commodity Trading Advisors (CTAs). Most managed futures fund managers
apply a systematic approach to trading, using technical and statistical analysis of price
and volume information to determine investment decisions. Once the manager has
developed the system, trading decisions are largely mechanical, and little or no discretion
is involved. Managers of other types of funds make discretionary decisions according to
current economic and political fundamentals. Score:
1/1
2. What do a hedge fund’s liquidity dates indicate?
A.
When new investors can purchase units in the fund.
B.
When the fund’s short positions are expected to be covered.
C.
When investors in the hedge fund can begin to redeem their units. 100%
Student Response
D.
When the fund is required to hold more than 50% of its assets in cash.
General Feedback: Liquidity dates refer to pre-determined times of the year when
investors may redeem units in a hedge fund. Some hedge funds can be liquidated only on
a quarterly or annual basis. Investors often need to give hedge funds advance notice of
their desire to redeem their units, such as 30 days or more in advance of the actual
redemption. Similar to traditional mutual funds, a hedge fund manager can refuse
redemptions if there is an occurrence in the markets that prevents the orderly liquidation
of the hedge fund’s investments. Score:
1/1
3. Which of the following documents details the objectives, risks, and terms of a hedge
fund structured as a limited partnership?
A.
Information folder
B.
Auditor’s report
C.
Offering memorandum
100% Student Response
D.
Simplified prospectus
General Feedback: Hedge funds targeted toward high-net-worth and institutional
investors are usually structured as limited partnerships or trusts, and are issued by way of
private placement. Instead of issuing a prospectus, these hedge funds usually issue an
offering memorandum, which is a legal document stating the objectives, risks and terms
of investment involved with a private placement. Score:
1/1
4. Which of the following represents a key benefit of investing in hedge funds?
A.
The funds make use of complex investment strategies.
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B.
Fund managers seek to achieve absolute returns.
100% Student Response
C.
The funds are lightly regulated.
D.
Fund managers use strategies that always hedge against market volatility.
General Feedback: There are many reasons for investing in a hedge fund. Compared
with mutual fund managers who seek to beat a market index, hedge fund managers seek
to achieve positive or absolute returns regardless of the market s direction.Score: 1/1
5.How would a hedge fund be classified if its primary objective is to exploit
inefficiencies or arbitrage opportunities in the pricing of related stocks, bonds and
derivatives?
A.
A directional hedge fund.
B.
An event-driven hedge fund.
C.
A relative value hedge fund. 100% Student Response
D.
A global macro hedge fund.
General Feedback: Relative value hedge funds pursue profits by exploiting
irregularities or discrepancies in the pricing of related stocks, bonds, or derivatives.
Score: 1/1
6. A hedge fund allocates $150,000 in capital to a long/short equity strategy between the
shares of FMI and BBD. If the hedged component of the strategy is long $100,000 worth
of FMI shares, what corresponding position will the manager take on the short side?
A.
Short $150,000 of the BBD shares.
B.
Short $100,000 of the BBD shares. 100% Student Response
C.
Short $100,000 of the FMI shares.
D.
Short $50,000 of the FMI shares.
General Feedback: The hedged component of a long/short equity fund consists of an
equal-dollar-value long and short stock positions. In this question, the fund is long
$100,000 FMI shares and will take a corresponding $100,000 short position in BBD.
Score: 1/1
7. The TKO Hedge Fund had $400 million in assets at the beginning of Year 1. The fund
manager was entitled to an annual incentive fee of 15% of the fund s return, subject to a
high-water mark of $400 million. Assuming no contributions or withdrawals to or from
the fund in Years 1 and 2, what incentive fees will the managers collect at the end of
Year 2 if the fund returns -10% in Year 1 and 20% in Year 2? Ignore the effect of
management fees and expenses.
A.
$4.8 million.
Student Response
B.
$6.0 million. 0%
C.
$12.0 million.
D.
$32.0 million.
General Feedback: An incentive fee is in addition to the management and
administration fees and is based on fund performance. The incentive fee is $4,800,000.
Step 1: the value of the fund at the end of year one is $360 million ($400 - ($400 × 10%)).
Step 2: the value of the fund at the end of year 2 is $432 million ($360 + ($360 × 20)).
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Step 3: the dollar amount of the increase in the fund is $32 million ($432 - $400), where
the $400 is the high water mark.
Step 4: the incentive fee is $4.8 million ($32 × 15%). Score:
0/1
8. If a hedge fund has a hurdle rate of 3%, which of the following statements is true?
A.
The manager of the hedge fund will earn an incentive fee based on the fund’s
return that is above 3%.
100% Student Response
B.
The manager of the hedge fund will earn a management fee only if the return on
the fund is greater than 3%.
C.
The manager of the hedge fund will earn an incentive fee only if the return on the
fund is greater than its benchmark return plus 3%.
D.
The manager of the hedge fund will earn a management fee only if the return on
the fund is greater than its benchmark return plus 3%.
General Feedback: A hurdle rate is the return above which a hedge fund manager
begins receiving incentive fees. In this example, if the hedge fund earns a 10% return for
the year, the fund will only calculate incentive fees on the 7% return above the hurdle
rate. Score: 1/1
9. MLA has just announced a hostile takeover bid for all outstanding shares of BLT. How
would a merger arbitrage hedge fund potentially try to profit from this takeover?
A.
By buying the shares of MLA and BLT.
B.
By buying the shares of BLT and selling short the shares of MLA. 100%
Student Response
C.
By selling short the shares of MLA and BLT.
D.
By buying the shares of MLA and selling short the shares of BLT.
General Feedback: This type of event-driven hedge fund attempts to take advantage of
price discrepancies between a target company s share and offering price. The strategy
involves taking a long position in the company being bought (BLT) and a short position
in the acquiring company (MLA). Score:
1/1
10. How can adding hedge funds to a portfolio reduce its overall riskiness?
A.
They are highly liquid investments.
B.
Their arbitrage opportunities produce riskless profits.
C.
They typically have a low correlation with traditional asset classes. 100%
Student Response
D.
The fund managers use contrarian strategies to help smooth returns.
General Feedback: Historically, hedge funds have produced returns that had a low
correlation with traditional asset classes like stocks and bonds. If these low correlations
continue, adding hedge funds to a portfolio will improve the portfolio s diversification
making it possible to reduce overall portfolio risk. Score: 1/1
11. An equity market neutral hedge fund’s manager believes that the market in equities
will be rising in the near future. What positions will he likely take in the fund?
A.
Overweight long positions.
B.
Equal long and short positions.
100% Student Response
C.
Long undervalued convertible securities and short common stocks.
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D.
Short equities, long short-term fixed income.
General Feedback: An equity market-neutral strategy is designed to exploit equity
market inefficiencies and opportunities by creating simultaneously long and short
matched equity portfolios of approximately the same size regardless of the anticipated
direction of the market. The goal of equity market-neutral investing is to generate returns
that do not depend on the direction of the stock market. Well-designed equity marketneutral portfolios hedge out the risks related to industry, sector, market capitalization,
currency and other exposures. Leverage is applied to enhance returns. Score:
1/1
12. Select the maximum percentage of a convertible arbitrage fund that may legally be
held in derivatives based on Canadian investment regulations?
A.
25%
B.
50%
C.
75%
D.
100% 100% Student Response
General Feedback: Under Canadian investment regulation, there is no limit to the
amount of derivatives that a hedge fund can hold in derivatives. This is one of the key
differences between these funds and mutual funds. Score: 1/1
13. A hedge fund manager shorts $500,000 worth of shares of ABC Mining Ltd and buys
$750,000 worth of shares of DEF Mining Ltd in the belief that DEF is underpriced
relative to ABC. What is the unhedged component of the strategy?
A.
$250,000
100% Student Response
B.
$500,000
C.
$750,000
D.
$1,250,000
General Feedback: In this type of strategy, typically used by a long/short equity
manager, there are two components: one, the hedged component in which the dollar
amounts are matched, and the unhedged component which is the amount that the dollar
value of the larger trade exceeds the dollar value of the smaller trade. In this example,
$750,000 - $500,000 = $250,000. Score:
1/1
14. Due to general pessimism about the fixed-income market DEF’s convertible bonds
are selling below their theoretical value. Recommend a strategy that a convertible
arbitrage manager could employ to take advantage of this situation.
A.
Short DEF Convertible bond, long mid-term corporate bond.
B.
Long DEF Convertible bond, short Government of Canada bond.
C.
Long DEF Convertible bond, short equivalent amount of equity. 100%
Student Response
D.
Short DEF Convertible bond, long equivalent amount of equity.
General Feedback: Convertible securities have a theoretical value that is based on a
number of factors, including the value of the underlying stock. When the trading price of
a convertible bond moves away from its theoretical value, an arbitrage opportunity exists.
This strategy typically involves buying undervalued convertible securities and hedging
some or all of the underlying equity risk by selling short an appropriate amount of the
issuer’s common shares. Properly executed, this strategy creates a net position with an
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attractive yield that can be almost completely unaffected by broader equity market
movements. Score: 1/1
15. Calculate the net exposure of a long/short equity fund with $10,000,000 in capital,
long positions of $10,000,000 and short positions of $2,000,000.
A.
80%
Student Response
B.
20% 0%
C.
$10,000,000
D.
$6,000,000
General Feedback: Net exposure is calculated as a percentage, not as an absolute
dollar value. In this example, the fund has net exposure of 80%, calculated as:
($10,000,000 – $2,000,000)/$10,000,000 = 80%
Score: 0/1
Calculate a hedge fund’s net market exposure if it is short 2,000 shares of ABC at $20
and long 3,000 share of DEF at $19.
A.
16.3%
B.
29.8% 100% Student Response
C.
42.5%
D.
70.1%
General Feedback: The two trades are worth $40,000 and $57,000 respectively. The
“unhedged” component is $17,000 (57,000-40,000= 17,000). The net market exposure is
calculated as (57,000-40,000)/57,000=29.8%. 21.17. Chapter 21: Hedge Funds.
Score: 1/1
Denis purchased junk bonds as part of a high-yield bond strategy he is pursuing for a
hedge fund he manages. Which of the following outcomes would most benefit this
position?
A.
Increase in the liquidity of the junk bonds. 0%
B.
Increase in the credit ratings of the junk bonds.
Student Response
C.
Increase in the coupon rate on the junk bonds.
D.
Increase in market interest rates.
General Feedback: A high-yield bond strategy invests in high-yield debt securities
(also known as junk bonds) of a company the manager feels may get a credit upgrade or
is a potential takeover target. Text Reference: Chapter 21: Hedge Funds.
Score: 0/1
What is the term used to refer to the time period during which initial investments cannot
be redeemed from a hedge fund?
A.
Lockup period.
100% Student Response
B.
Deferral period.
C.
Accreditation period.
D.
Pre-redemption period.
General Feedback: A lockup refers to the time period that initial investments cannot
be redeemed from a hedge fund. Some hedge funds require lockups of three years or
more! While lockups of this duration are not common for hedge funds offered on a
continuous basis in Canada, some funds do have initial lockup periods or charge an early
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redemption fee if the initial investment is redeemed within the first three months to one
year. Once the lockup period is over, the investor is free to redeem shares on any liquidity
date specified in the offering memorandum. Chapter 21: Hedge Funds.
Score: 1/1
The managers of ABL Hedge Fund strongly believe that DEF Co. is about to be acquired
by JKL Inc. If ABL pursues a merger arbitrage strategy, how can the fund profit from this
position?
A.
Buy the shares of DEF and short the shares of JKL. 100% Student Response
B.
Buy the shares of JKL and short the shares of DEF.
C.
Go long the shares of both companies.
D.
Go short the shares of both companies.
General Feedback: A merger or risk arbitrage strategy invests simultaneously in long
and short positions in the common stock of companies involved in a proposed merger or
acquisition. The strategy generally involves taking a long position in the company being
acquired and a short position in the acquiring company. The hedge fund manager
attempts to take advantage of the differential between the target company’s share price
and the offering price. Typically, the share price of the target company rises and the share
price of the acquiring company drops after a takeover or merger announcement. Text
Reference: Chapter 21: Hedge Funds.
Score: 1/1
What is the primary aim of most hedge funds?
A.
To increase exposure to foreign investments.
B.
To minimize risk and deliver positive returns under all market conditions. 100%
Student Response
C.
To avoid cumbersome regulation.
D.
To generate the highest return possible.
General Feedback: Absolute return with minimal risk is the primary aim of most
hedge funds. No matter how the market performs, the hedge fund manager is expected to
earn positive returns under all market conditions. Text reference: Chapter 21: Hedge
Funds.
Score: 1/1
The Lakefield Hedge Fund has $10 million in capital invested in Canadian stocks.
Presently, the fund is long $10 million and short $6 million. Which of the following
represents the approximate net exposure of this fund?
A.
25% long.
B.
40% long.
100% Student Response
C.
60% long.
D.
150% long.
General Feedback: A long /short equity fund's net exposure = (long exposure short
exposure) / capital. In this example, the net exposure = ($10 million - $6 million) / $10
million or 40%. Text reference: Chapter 21: Hedge Funds.
Score: 1/1
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Which of the following legal documents would an investor acquire to find out more about
the risks and objectives of a hedge fund?
A.
A preliminary prospectus.
B.
An offering memorandum.
Student Response
C.
A final prospectus.
D.
An annual information form. 0%
General Feedback: Hedge funds usually issue an offering memorandum, a legal
document stating the objectives, risks and terms of investment involved with a private
placement. Text reference: Chapter 21: Hedge Funds.
Score: 0/1
Which of the following is one advantage of holding a fund of hedge funds (FoHF)
compared to holding a single hedge fund?
A.
Lower operating fees
B.
Less leverage.
C.
Greater volatility in fund holdings.
D.
Greater diversification opportunities.
100% Student Response
General Feedback: A fund of hedge funds (FoHF) is a portfolio of hedge funds,
overseen by a manager who determines which hedge funds to invest in and how much to
invest in each. One of the key advantages of a FoHF structure is the ability to diversify
with a smaller investment. There is also reduced volatility holding a FoHF compared to
holding a single hedge fund. Disadvantages include additional costs and fees and
additional sources of leverage. Text Reference: Chapter 21: Hedge Funds.
Score: 1/1
What is indicated by a hedge fund’s liquidity dates?
A.
When the fund’s short positions are expected to be covered.
B.
When the fund is required to hold more than 100% of its assets in cash.
C.
When investors in the fund can redeem their units. 100% Student Response
D.
When new investors can buy units in the fund.
General Feedback: Liquidity dates refer to pre-specified times of the year when
investors may be allowed to redeem units in a hedge fund. Some hedge funds can be
liquidated only on a quarterly or annual basis. Investors often need to give hedge funds
advance notice of their desire to redeem their units, such as 30 days or more in advance
of the actual redemption. Similar to traditional mutual funds, a hedge fund manager can
refuse redemptions if there is an occurrence in the markets that prevents the orderly
liquidation of the hedge fund’s investments. Chapter 21: Hedge Funds. Score: 1/1
The primary objective of the Davidson Hedge Fund is to invest in the equity or debt of
companies that are facing bankruptcy or in the midst of a reorganization. Which of the
following hedge fund strategies is being used?
A.
Distressed securities funds. 100% Student Response
B.
Relative value funds.
C.
Dedicated short bias funds.
D.
Equity market neutral funds.
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General Feedback: Distressed securities funds invest in the equity or debt of
companies that are in or facing bankruptcy, reorganization or are in financial difficulty.
Distressed securities generally sell at deep discounts reflecting the weak credit quality of
the securities. Text reference: Chapter 21: Hedge Funds.
Score: 1/1
Calculate the incentive fee paid to a hedge fund manager with a hurdle rate of 4% and an
annual fund return of 18%.
A.
4%
B.
14% 100% Student Response
C.
18%
D.
22%
General Feedback: A hurdle rate is the rate that a hedge fund must earn before its
manager is paid an incentive fee. In this example, if a fund has a hurdle rate of 4%, and
the fund earns 18% for the year, incentive fees will be based only on the 14% return
above the hurdle rate, subject to any high-water mark. Chapter 21: Hedge Funds.
Score: 1/1
A hedge fund with $100 million in capital purchases shares worth $100 million and goes
short shares worth $80 million. What is the fund's leverage factor?
A.
0.8x
B.
1.0x
C.
1.8x 100% Student Response
D.
1.2
General Feedback: Many long/short funds use some leverage. One method of
calculating the fund s leverage is to add the fund s short market value to the long market
value (this sum is called the fund s gross exposure) and then divide by the net capital
invested. ($100 + $80)/$ 100 = 1.8x. Text reference: Chapter 21: Hedge Funds.
Score: 1/1
Your client has a portfolio worth $1.2 million. Of this amount, $800,000 is in a nonregistered account and $400,000 is in an RRSP. Her income in each of the last two years
was $190,000, and she expects to earn about $195,000 this year. Is your client considered
an accredited investor, and if not, why not?
A.
Yes.
Student Response
B.
No, because she expects to earn less than $200,000 this year.
C.
No, because her income in each of the last two years was less than $200,000.
0%
D.
No, because the value of her non-registered investments is less than $1 million.
General Feedback: Accredited Investor Exemption: The accredited investor exemption
allows hedge funds to be sold without a prospectus to institutions and individuals who are
considered accredited investors. Individuals must beneficially own (alone or with a
spouse) financial assets having an aggregate realizable value (before taxes, but net of any
related liabilities) exceeding $1 million. Individuals may also be accredited investors if
they have net income before taxes exceeding $200,000 (or $300,000 if combined with a
spouse s income) in each of the two most recent years, and a reasonable expectation of
8
exceeding the same net income level in the current year. Text Reference: Chapter 21:
Hedge Funds.
Score: 0/1
Carol, a hedge fund manager, feels that with falling interest rates there is a huge
opportunity for growth in Europe. Therefore, she has taken long positions in European
assets. She also feels that with a runaway deficit, the United States is heading into a
recession and has shorted the US dollar. Which of the following hedge fund strategies is
Carol following?
A.
An equity market neutral strategy.
B.
A convertible arbitrage strategy.
C.
A long / short equity strategy.
D.
A global macro strategy.
100% Student Response
General Feedback: Global macro investing makes bets on major events affecting
entire economies. The goal is to attempt to profit from changes brought about by shifts in
government policy that alter interest rates, thereby affecting currency, stock and bond
markets. Global macro funds participate in all major markets including equities, bonds,
currencies and commodities. Text reference: Chapter 21: Hedge Funds.
Score: 1/1
Eric purchased a hedge fund in his investment account and shortly thereafter tried to sell
it. He wanted to use the proceeds to invest in a start-up tech company that looks very
promising. Unfortunately, Eric was not allowed to sell his hedge fund investment and
was told that the hedge fund requires a minimum duration for investments placed in the
fund. Which of the following features of the hedge fund prevented Eric from selling his
fund?
A.
A cooling off period.
B.
A lockup period.
100% Student Response
C.
A waiting period.
D.
A holding period.
General Feedback: A lockup refers to the time period that initial investments cannot
be redeemed from the fund. Once the lockup period is over, the investor is free to redeem
shares on any liquidity date specified in the offering memorandum. Text reference:
Chapter 21: Hedge Funds.
Score: 1/1
Which of the following ranks the order of hedge fund strategies from lowest to highest
exposure to market direction?
A.
Event-driven, directional, relative value.
B.
Event-driven, relative value, directional.
0%
C.
Relative value, directional, event-driven.
D.
Relative value, event-driven, directional.
Student Response
General Feedback: Major Hedge Fund Categories Relative Value Strategies (Low
Exposure to Market Direction) Event-Driven Strategies (Medium Exposure to Market
Direction) Directional Strategies (High Exposure to Market Direction), Equity market
neutral Merger or risk arbitrage Long/short equity, Convertible arbitrage Distressed
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securities Global macro, Fixed-income arbitrage High yield bond Emerging markets,
Managed futures, Dedicated short bias. Text reference: Chapter 21: Hedge Funds.
Score: 0/1
If a hedge fund lost $10 million in its first year of operation and gained $15 million in its
second year, what incentive fee did the manager earn in the first two years? Assume
incentive fees are 10% of profits and a high watermark applies.
A.
$0
B.
$250,000
C.
$500,000
100% Student Response
D.
$700,000
General Feedback: In addition to management and administration fees, hedge fund
managers often charge an incentive fee based on performance. Incentive fees are usually
calculated after the deduction of management fees and expenses and not on the gross
return earned by the manager. This detail can make a significant difference in the net
return earned by investors. The calculation of incentive fees can be subject to a highwater mark, a hurdle rate, or both. ($15 million - $10 million) x 10% = $500,000. Text
reference: Chapter 21: Hedge Funds.
Score: 1/1
Which of the following best describes the hurdle rate included with most hedge funds?
A.
The minimum portfolio return necessary for a hedge fund manager to start
collecting incentive fees.
100% Student Response
B.
A restriction placed on the hedge fund manager where only a maximum of 3% of
the portfolio can be in short sales.
C.
A cap where the hedge fund manager can only receive a maximum of 3% the
annual profits as a performance fee.
D.
A provision whereby 3% of the portfolio must be allocated to cash to account for
possible redemptions.
General Feedback: Hurdle rates are usually based on short-term interest rates. Text
reference: Chapter 21: Hedge Funds.
Score: 1/1
Ideally, what type of risk are assets within a hedged structure of a long/short equity fund
exposed to?
A.
Stock selection risk only.
Student Response
B.
Both stock picking and market risk. 0%
C.
Market risk only.
D.
They are risk-free.
General Feedback: The manager is not trying to eliminate market effects or market
trends completely, as would be the case with an equity market-neutral strategy; rather, he
or she takes both long and short positions simultaneously, depending on the outlook of
specific securities. With a long/short equity strategy, managers try to buy stocks they feel
will rise more in a bull market than the overall market, and short stocks that will rise less.
In a down market, good short selections are expected to decline more than the market and
good long selections will fall less. The only risk that the hedged component is exposed to
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is stock selection risk, which is the risk that the value of the shares of one company will
change more than the value of the shares of another company. Text reference: Chapter 21:
Hedge Funds.
Score: 0/1
Derek is a hedge fund manager and he takes significant positions in companies he thinks
are about to experience unique situations such as mergers and takeovers. Which of the
following hedge fund strategies is Derek adhering to?
A.
A relative hedge fund strategy.
B.
A directional hedge fund strategy.
C.
An event-driven hedge fund strategy.
100% Student Response
D.
A dedicated short bias hedge fund strategy.
General Feedback: Event-driven hedge funds seek to profit from unique, particular
events such as mergers, acquisitions, stock splits and buybacks. Text reference: Chapter
21: Hedge Funds.
Score: 1/1
Which of the following strategies attempts to exploit inefficiencies or differences in the
pricing of related stocks, bonds, or derivatives?
A.
Directional strategies.
B.
Event-driven strategies.
C.
Relative value strategies.
100% Student Response
D.
Managed futures strategies.
General Feedback: Relative value strategies attempt to profit by exploiting
inefficiencies or arbitrage opportunities in the pricing of related stocks, bonds, or
derivatives. Hedge funds using these strategies generally have low or no exposure to the
underlying market direction. Text reference: Chapter 21: Hedge Funds. Score: 1/1
What type of investors are hedge funds generally not suitable for?
A.
Investors with RRSPs.
B.
Investors with long time horizons.
C.
Investors in the highest tax bracket.
D.
Investors with high liquidity requirements. 100% Student Response
General Feedback: Unlike mutual funds, hedge funds are typically not able to
liquidate their portfolios on short notice. Holding less liquid investments often produces
some of the excess returns generated by hedge funds. This liquidity premium is part of
the trade-off against traditional investments. In light of this, there are often various forms
of liquidity constraints imposed on hedge fund investors. They are not suitable for
investors with high liquidity requirements. Text reference: Chapter 21: Hedge Funds.
CSC FAQs - Module 21: Hedge Funds
OVERVIEW OF HEDGE FUNDS
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1. Some of these hedge fund strategies seem pretty risky. Why are they called hedge funds if they
present so much risk?
I think the following from the early part of Chapter 21 will help solve your dilemma:
“Despite the popular name, some funds do not hedge their positions at all. Therefore, it is
best to think of a hedge fund as a type of fund structure rather than a particular fund
strategy.”
2. How do you define a sophisticated investor?
As the text mentions, an investor must be classified as an accredited investor or
sophisticated investor to buy hedge funds.
The provincial securities commission defines who qualifies as an accredited investor or
sophisticated investor. To find the definition of accredited investor or sophisticated
investor, you need to check with the securities commission for the province in which you
reside. However, most definitions are based purely on the wealth of the investor (for
example, the investor combined with spouse must have financial assets exceeding a
specified dollar amount), and the investor's net income (for example, the investor
combined with their spouse must have at a net income exceeding a specified dollar
amount in each of the last two years).
BENEFITS AND RISKS OF HEDGE FUNDS
3. What is low correlation?
Low correlation would be a value close to zero, meaning there is no specific relationship
between the hedge fund and the market to which the fund is compared - i.e., the returns
produced by the hedge fund are independent from the performance of market to which
the fund is compared. A number close to negative one would be a high negative
correlation and would mean that as the market moves in one direction, the hedge fund
moves in the opposite direction without fail.
4. What is a “home run” in the context of the markets?
A home run in baseball is considered to be a big hit. The expression can be applied to
many types of activities, including the markets. When a person strikes out (another
baseball analogy), it means the person has lost money or made no money on a trade. A
home run is the opposite - the person made a lot of money from a trade.
5. What are pro-forma returns?
Pro forma means that the results presented are based, in part, on assumptions rather than
actual fact. That means the results presented are, at best, hypothetical. The term is most
often associated with financial statements where the data provided is done in advance of
the actual fact, meaning the information presented is based on hypothetical information.
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6. I thought that a closed-end fund couldn’t redeem units from investors?
The text states the following: “Closed-end funds are pooled investment funds that issue a
limited or fixed number of shares. The number of shares or units in closed-end funds
remains fixed, except in rare cases of an additional share offering, share dividend, or
share buy-back."
"Funds that have the flexibility to buy back their outstanding shares periodically are
known as interval funds or closed-end discretionary funds. They are more popular in the
United States. In Canada, closed-end funds may also be structured with buyback or
termination provisions."
So closed end funds indeed have the capability of redeeming shares from investors based
on certain conditions. What separates closed end funds from open-end funds is that openend funds continuously redeem units (i.e., every business day of the year, with little or no
exception).
7. Can you please explain the high water mark and hurdle rate and provide an example?
The hurdle rate is an additional limitation on when a manager can collect an incentive fee.
For example, if you insist that the manager can collect incentive fees only after 5% of
new profits, you are describing both a high water mark and hurdle rate. In other words, if
the manager does not turn any new profits, there are no incentive fees paid at all. If the
manager does turn a profit, incentive fees would be paid only if a particular performance
has been achieved.
So if the high water mark isn't reached, no point in discussing incentive fees. If the high
water mark is reached, the manager must exceed a particular % gain before receiving any
incentive fees.
The hurdle rate acts as a means of targeting a particular gain per year for which a
manager must strive. Think about the following scenario that excludes a hurdle rate:
Suppose the manager has $500 million under management and will receive performance
fee of 15% on new profits. In the first year, the fund increases in value to $501 million.
That leads to an incentive fee of $150,000. Pretty good for a year's work, even though the
fund increased in value by only 0.20%. So the next year, the fund increases in value to
$502 million and the manager receives an incentive fee of $150,000 again, even though
the fund increased in value by only 0.199%. Not much motivation to make the assets
grow when even just a small gain can provide a large incentive fee.
But see what happens now if there is a hurdle rate of 5% before the manager can collect
incentive fees. If the fund started at $500 million, the fund would have to increase to
$526 million in order for the manager to collect the same $150,000 incentive fee in the
first year. The hurdle rate is a great way to target a return on the fund.
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8. What is a benchmark?
A benchmark is used for performance comparisons. For example, the return generated by
a portfolio manager who invests in large-cap Canadian equity stocks may be compared to
the S&P/TSX composite index. The index is the benchmark against which the portfolio is
compared.
HEDGE FUND STRATEGIES
9. In a merger arbitrage, why would one company’s stock rise while the other falls?
Typically in an acquisition, the company to be acquired experiences an increase in stock
price (makes sense since an acquisition price is generally higher than the current market
price of the stock, so the price creeps higher).
At the same time, many view the acquiring company as being at a disadvantage for
increasing in size, possibly diluting shareholder equity, and taking on more debt, etc. This
can be a negative for the company and they may experience some downward price
pressure.
10. In a long/short equity strategy, how can the investor make money in both market directions?
If expected to make a profit under all market conditions, the hedged component would
presumably profit in a rising market if the longs increase more in value than the shorts
fall in value. In a falling market the hedged component would presumably profit if the
shorts increased in value more than the longs fell in value. This kind of circumstance
depends on the ability of the manger to select the right stocks.
One would definitely not make a directional bet unless there was a definite belief in
market direction.
11. In the long/short equity example in the text, why would the portfolio decline by only 8% if the
market fell by 20%?
Please look at the example again in the text. Notice that the manager invests $600 long in
General Motors and $600 short in Ford Motor Company. The manager makes a further
directional bet in the amount of $400 on General Motors.
Based on this, the Net Exposure is: ($1,000 - $600) / $1,000 = 40%
When the market falls by 20%, the drop in the price of Ford theoretically leads to a short
sale profit that eliminates the loss on $600 of the stock invested in General Motors. That
leaves another $400 (or 40% based on the formula) exposed in the market.
If the market falls by 20%, the $400 is reduced to $320 (an $80 loss). Based on the
formula in the text, this $80 loss represents an 8% decline.
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Or, as the text states, if the market declines by 20%, the overall fund's exposure to this
decline would only be 40% of the market decline, or 8%.
What if the market went up in price? Since the $600 long stock is cancelled out by the
$600 short stock, the only exposure to the market rise is the remaining $400 in General
Motors. If the market rises by 20%, the $400 increases to $480. Based on the formula in
the text, this $80 gain represents an 8% increase.
12. Don’t simultaneous long and short positions in a stock result in the investor not owning anything
at all?
Taking a long and short position simultaneously means you are creating a long position at
the same time that you are creating a short position. The long and short stocks, however,
are different companies. To take a long and a short position in the exact same stock
cancels each other out. No matter what the market does, you wouldn't make any money at
all.
13. What does net exposure refer to?
Net exposure refers to how much you are participating in a market and in what way.
For example, if you have nothing but long stocks in your portfolio, your net exposure is
100% long. In other words, you are fully exposed to market influences - as the market
rises or falls, in theory, you will participate 100% in that market move.
If you have nothing but short stocks in your portfolio, your net exposure is 100% short. In
other words, your are fully exposed to market influences - as the market rises or falls, in
theory, you will participate 100% in that market move. If you have 50% of your portfolio
value in long stocks and 50% of your portfolio in short stocks, you have no net exposure,
because the two positions cancel each other out.
Whether the market goes up or down, in theory, your portfolio should remain unchanged.
There is a formula for net exposure that you can examine in Chapter 21 of your text.
FUNDS OF HEDGE FUNDS
14. What are “fund of funds”?
“Fund of funds” is the generic term for a fund that invests in other funds, rather than in
individual securities. There are plenty of mutual funds out there that are structured as a
fund of funds, where the mutual fund invests exclusively in other mutual funds. One
might also find a hedge fund that invests exclusively in other hedge funds, rather than
implementing strategies with individual securities.
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