Topic 4: Hedge Funds
I attempted these without reading the text, I was confident with all accept the method used for the exponential moving average which I had to check with the book (also had to clarify what the book defined as “opportunistic investing”). Probably the easiest workbook q’s so far.
CAIA Level I: An Introduction to Core Topics in Alternative Investments. Second Edition. 2012.
Wiley. ISBN: 978-1-118-25096-9. Part Three, Hedge Funds, Chapters 11 – 17.
Chapter 11
Introduction to Hedge Funds
Exercises
1. Comment on the following statement: “We don’t know the exact size of the hedge fund
universe because the hedge fund industry has always been unregulated.”
A: TRUE
Problems 2 to 5
Hedge fund ABC has a 2 and 20 fee arrangement with no hurdle rate and a net asset value (NAV) of $300 million at the start of the year. At the end of the year, before fees, the NAV is $335 million.
2. Assuming that management fees are computed on start-of-year NAVs and are distributed annually, and that the fund had no redemptions or subscriptions during the year, find the annual management fee.
A: 300M * 0.02 = 6M
3. Find the incentive fee for the managers of hedge fund ABC.
A: 335 – 6 – 300 = 29M * 0.2 = 5.8M
4. Find ABC’s ending NAV after fees.
335 – 6 – 5.8 = 323.2M
5. Suppose that at the end of the year, before fees, NAV was $277 million instead of the original $335 million. Calculate the new annual management fee, incentive fee, and ending NAV after fees for hedge fund ABC.
management fee would be 6M
0 incentive fee
ending NAV = 277 – 6 = 271M
6. Use options theory to support the following hypothetical statement: “Most global macro hedge funds had their worst ever returns last year. In fact, the average global macro hedge fund lost around 30%. Therefore, I predict that in coming months many global macro fund managers will start new hedge funds.”
A macro hedge fund is like a OTM call option for the hedge fund manager. The strike price is the high water mark for NNP. A 30% drop in returns means that they are much further OTM and have a lot of ground to cover before being able to earn incentives. Therefore it’s easier to open a new fund, i.e. a new call option that is less OTM, i.e. “restriking” the option.
Another option to the hedge fund manager would be to increase volatility or leverage up to try and make their money back the following year. Both approaches are bad for clients.
Chapter 12
Hedge Fund Returns and Asset Allocation
Exercises
1. Exhibit 1 below presents performance statistics for U.S. stocks, U.S. bonds, and hedge funds. XYZ is a pension fund that currently has allocations only to traditional investments. Peter Lanz, a portfolio manager at XYZ pension fund, has been recently pondering whether to recommend including hedge funds in XYZ’s portfolio. However, Mr. Lanz has become pessimistic about adding hedge funds to XYZ’s portfolio after finding out that the correlation coefficient between hedge funds (CISDM Hedge Fund Equally Weighted Index) and U.S. stocks (S&P 500) was 0.79 during that same period (2001-2008). Does the evidence in Exhibit 1 imply that there are no benefits of adding hedge funds to a portfolio of traditional investments?
Exhibit 1. Need to see the PDF from CAIA (Sorry – doesn’t copy past well).
Answer: No, the correlation might not be significant and might not be indicative of the future. Also need to consider the risk-return which is better than stocks and uncorrelated with bonds which make it possibly a good addition.
2. Looking at Exhibit 2 below, what would explain the relatively high correlation between hedge funds (CISDM Hedge Funds Equally Weighted Index) and U.S. stocks (S&P 500 Index) that was documented in Problem 1?
Exhibit 2: Need to see the PDF from CAIA (Sorry – doesn’t copy past well).
Probably because of the period chosen i.e. outlier events of 2007/2008 in which both hedge funds and the overall market were hammered. Another way of explaining: it is probably because of equity exposure in hedge funds that make up the index.
3. Julia Smith is the hedge fund manager of ABC Tech, a fund specializing in the technology industry. She has followed the tech industry for years and has developed a superior information set. On the long side, the manager purchases those stocks that she believes will be the winners. On the short side, she takes short positions in those stocks that she believes will decline in value. The fund offers investors the ability to extract value on both the long side and the short side of the tech market. Can the investment strategy of ABC Tech be characterized as opportunistic investing? Explain.
YES.
4. Consider an absolute return program where a portfolio has a specific target rate of return, volatility, and largest acceptable drawdown, while the underlying hedge funds have a target range of rates of return, a target range of volatilities, and a target largest acceptable drawdown. Liquidity for both the absolute return portfolio and the individual hedge funds is semiannual. Why does the liquidity of the absolute return portfolio have to be the same as that of the individual hedge funds?
So the investor can redeem within the same time frame.
5. Comment on the following statement: “Published hedge fund indices have significant survivorship bias.”
Hedge fund indexes may not contain data from hedge funds that stop publishing their returns if they blowup, therefore they are upward biased. However, if they do then they will retain the old, poor history and not contain survivorship bias.
6. Comment on the following statement: “Published hedge fund indices have significant instant history bias.”
Unless the index is revised (which is unlikely) it will not have backfilling / instant history bias.
7. XYZ started as a convertible bond arbitrage hedge fund in 2003. In 2007, based on the perceived availability of attractive opportunities in the market, the fund morphed its trading activities into being dominated by merger arbitrage trading.
What is the term used in the hedge fund literature to refer to this problem?
Style drift or strategy drift
8. Continuing with the previous problem, assume that XYZ Fund reports its returns to Hedge Fund Index Inc. but is not reclassified as a merger arbitrage fund. In 2007, XYZ had a return of -6.2% while the Convertible Bond Trading Hedge Fund Index and the Merger Arbitrage Hedge Fund Index published by Hedge Fund Index Inc., exhibited returns of 4.1% and 3.8%, respectively. What consequence would the wrong classification of XYZ as a convertible bond trading hedge fund have on the returns reported by the Convertible Bond Trading Hedge Fund Index and the Merger Arbitrage Hedge Fund Index?
It would make them errorneus and could have an impact on their correlation, the impact is probably very small in reality depending on the composition of the index.
9. Critique the following statement: “I disregard the information offered by those hedge fund index providers that include in their indices hedge funds which are closed to new investors.”
Closed funds represent a very large portion of the industry so they should be considered as an open only index might not be truly representative of average performance
10. Provide two arguments in favor of the use of asset-weighted hedge fund indices.
allows for better comparison with other cap weighted indices (which is the common approach) also it’s best represent the experiences of the investors
11. Calculate an equally-weighted return and an asset-weighted return for an index that includes the following five hedge funds for the month of October. Comment on the differences in the results obtained.
It didn’t copy and paste properly but:
Equal weight is the simple average
Asset weight would multiply the return by the weight of the asset vs the total
(-4% + 3% +1% + 5% + 6%) / 5 = 2.2%
The asset-weighted index return for October was:
[(-4% x 300m) + (3% x 50m) + (1% x 100m) + (5% x 40m) + (6% x 60 m)] / 550 m
= -0.71%
The equally-weighted return was positive because only one of the five hedge funds (hedge fund I) had a negative return, and that negative return was not large enough (in absolute value) to compensate the four positive returns of the remaining hedge funds when equally averaged.
The asset-weighted return was negative even though only one of the five hedge funds had a negative return (hedge fund I). This is because hedge fund I is larger in size than the other four hedge funds combined and also because its negative return was large enough (in absolute value).
Chapter 13
Macro and Managed Futures Funds
Exercises
1. A stock price experiences the following five consecutive daily prices:
Day -5 -4 -3 -2 -1
Price 205 204 201 201 195
What are the 3-day simple moving average prices on days -1 and 0?
606 / 3 = 202 for -1
597 / 3 = 199
2. A stock price experiences the following five consecutive daily prices:
Day -5 -4 -3 -2 -1
Price 205 204 201 201 195
What are the 3-day weighted moving average prices on days -1 and 0?
195 * 3 + 201 * 2 + 201 * 1 / 6 = 198
[(201 x 3) + (201 x 2) + (204 x 1)]/6 = 201.50.
3. A stock price experiences the following five consecutive daily prices:
Day -5 -4 -3 -2 -1
Price 202 204 210 213 216
What are the exponential moving average prices on days -1 and 0 using λ=0.3?
Assume that the exponential moving average up to and including the price on day -3 (i.e., the day -2 average) was 203.
The day -1 price is λ * the -2 price = 0.3 * 213 plus the previous exponential moving average which is … λ(1-λ)^n = 0.3(1-0.3)^ n
You can also just use the previous exponential moving average value if you have it (as per this question) so you would multiply the previous average by (1-0.3) and add it together with the latest price multipled by 0.3 to get the new exponential average.
4. XYZ, a stock listed on the Tokyo Stock Exchange, has experienced the following ten consecutive daily high prices.
Day -10 -9 -8 -7 -6 -5 -4 -3 -2 -1
Price ¥519 ¥522 ¥523 ¥533 ¥530 ¥517 ¥523 ¥525 ¥529 ¥533
What is the day 0 price level that would signal a breakout and possibly a new long position using these ten days of data as being representative of a trading range?
534
5. If the price series of the previous problem contained the low prices for each day, what is the day-0 price level that would signal a breakout and possibly a new short position using these ten days of data as being representative of a trading range?
516
CAIA Level 1 Study Notes 