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Special Topics in Finance: Hedge Funds

Simon Business School

FIN441C Special Topics in Finance: Hedge Funds

Assignment #1

Hedge Fund Overview, Fund Organization and Structure

30 September 2016

Assignment By
Yuvraj Chauhan
Cell 347-545-8178

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FIN441C Special Topics in Finance: Hedge Funds

Q1. What are the key distinguishing features of hedge funds?
The key distinguishing features of a hedge fun are as follows:
1. Flexibility: It offers almost complete flexibility in relation to investments, including both long and short
positions. The objective of hedge funds is to maximize their absolute returns, regardless of their investment
strategies, which allows them to have a greater range of types of investments compared to other sorts of
2. Leverage: It provides the ability to borrow money, and further increase leverage through derivatives in an
effort to enhance returns. . Hedge funds use a great amount of leverage to increase their investors returns, as
well as the management fees. Before 2007, the global hedge fund leverage ratio was an implied 3.4, which is
not very common in funds (except maybe Private Equity firms)
3. Regulations: It faces little to minimum regulations. Hedge funds are barely regulated (in the US and many
other countries) since they attract sophisticated institutional and high-net-worth investors. These types of
investors are normally very diligent on their investments and therefore do not need help from the regulators.
However, there are some limitations on the total number of investors a fund can have.
4. Illiquidity: It also comes with some level of illiquidity because an investors ability to get an investment back is
restricted through lock-up agreements, this may prevent the liquidity of the investment for the initial years
(1st and 2nd), and quarterly disbursement limitations thereafter (subject to gates, which may further limit
5. Investors: Investors include only wealthy individuals and institutions such as university endowments, pension
funds, and other qualified institutional buyers (except through fund of fund investment, which are available to
a broader array of investors). This enables the hedge fund to raise significant amounts of money from a small
number of players which is easier to manage- and at the same time, pick up powerful supporters (investors)
to facilitate the funds operations.
6. Fees Structure: It also as a performance fees associated with it, which rewards the fund manager for the
performance of the fund, this helps attract skilled fund managers to the funds.
Q2. What types of investors are hedge funds focused on?
As discussed in the above questions - the type of investors, which a hedge fund usually focuses on are High net
worth individuals. Until 200, HNWI (High Net Worth Individual) used to make up the largest share of the hedge
fund investors, holding more than half of the assets. While this investor class has doubled in number and assets
over the past decade, its share of all hedge fund declined to 30% during 2008.
The other investor classes, which has grown and become a part of the hedge fund industry are
Institutional investors such as pension funds, insurance companies, endowments, and foundations. These
investors now account for 38% of the hedge fund assets.
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FIN441C Special Topics in Finance: Hedge Funds

HNWI, family offices, and Institutional investors also invest in hedge funds via funds-of-funds, which accounted
for around 32% of hedge fun assets during 2008.

Q3. In the aftermath of the 2007-2008 financial crisis, it is especially important to adjust hedge fund returns
data for a particular type of bias. What is the name of the bias? Briefly explain
A major problem with the global hedge fund returns is that, as these types of funds do not require to report
periodically their financial statements, the returns might be skewed since there are no records of the failed funds,
or as more funds are taken into consideration to calculate the global returns, hedge funds have the luxury of only
informing the positive past returns. This type of bias is called survivorship bias some funds are dropped from the
database when they are liquidated or fail.
During the period of 2007-2008, which saw a devastating financial crisis, a lot of hedge funds failed to deliver and
died, and their reruns got removed from the database. Living funds tend to have higher returns than the dying
funds, so if the returns of the dying funds is left out the overall return of the hedge funds is overstated. Hence, it
is important to adjust hedge fund returns data for the survivorship bias.

Please answer the following question based on Ibbotson, R., Chen, P., Zhu, K., 2011. The ABCs of hedge funds:
alphas, betas, and costs. Financial Analysts Journal 67(1), 1525:

Which fund investment styles had the highest alpha?

The investment style which had the highest alpha was Long-short-equity, the study recorded that this
particular style of investing delivered an annual alpha of 4.79%, after accounting for the hedge fund fee,
and a compounded annual post fee-return of 9.99%. The Emerging Markets was the second strategy
yielding a slightly lower alpha of 4.66%, post fee.

Why do some hedge fund alpha regressions, such as the Fung-Hsieh model in Table 7, include
nontraditional beta factors?
The additional beta are known strategies (which do not require significant management skills), and by
adding them to the model, perhaps more can be explained by this extra factor, leaving a smaller alpha.
The reason for including additional beta factors in the model is to prove that the alphas are actually real.
In other words, hedge fund managers are paid to produce a significant alpha, but if there is a model (with
more betas for known strategies) that is very correlated with the hedge funds strategy, it means that
similar results could have been produced with common strategies and there is little or no contribution
from the management of the hedge fund.

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FIN441C Special Topics in Finance: Hedge Funds

Hence, alphas are only undiscovered betas or strategies, and as the markets are further understood, the
alphas will be more and more explained by the betas.

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