Home  >  115 CFA  >  115.090.01.02 Alternative Investments - Reading 50 - 2. Hedge funds

2. Hedge funds

d. describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence;

## e. describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds; ## f. describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure;

What is a hedge fund? Hedge funds utilize alternative investment strategies for the purpose of achieving superior returns relative to risk (i.e., return vs. standard deviation).

What is the structure of a hedge fund? A hedge fund is a private “pool” of capital for accredited investors only and organized using the limited partnership legal structure. The general partner is usually the money manager and is likely to have a very high percentage of his/her own net worth invested in the fund.

For a hedge fund, what is event-driven investing? Event-driven investing is an investing strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spinoff.

What is the event-driven hedge fund investing strategy of Merger arbitrage? Before the effective date of a merger, the stock of the acquired firm typically sells at a discount to its announced acquisition value. A risk arbitrage involves buying stocks of the acquired firm and simultaneously selling the stocks of the acquirer. However, there is the risk that the merger may fall though.

What is the event-driven hedge fund investing strategy of Distressed debt investing? The securities of companies having financial problems usually sell at deeply discounted prices. Distressed securities funds take bets on the debt and/or equity securities of such companies. For example, if a fund manager believes such a company will successfully return to profitability, he or she will buy its securities. If the manager believes the company’s situation will deteriorate, he or she will take a short position in its securities.

What is the Activist event-driven hedge fund investing strategy? A fund takes large positions in companies and uses the ownership to participate in the management.

What is the relative-value arbitrage hedge fund investing strategy? A relative-value arbitrage strategy seeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securities - thereby allowing investors to potentially profit from the “relative value” of the two securities.

What is the macro fund hedge fund investing strategy? Macro funds take bets on the direction of a market, a currency, an interest rate, a commodity, or any macroeconomic variable.

What is the hedge fund investing strategy called Equity hedge? Equity hedge strategies take long and short positions in equity and equity derivative securities.

What is a hurdle rate? Incentive fees are not paid until the returns exceed the rate. It may be based on an agreed upon rate, LIBOR or the yield on U.S. treasury bills.

What is a High water mark and how is it used as an incentive for hedge fund managers? Investors in hedge funds enter the fund at a certain net asset value (NAV). If the fund loses money in a given year and then makes back that money in a subsequent year, the investor is usually not required to pay a management fee on any portion of the upside in the subsequent year that was below the entering NAV. The high water mark limits the risk taking of the fund. Without it, the manager gets all the upside from big bets but suffers little from the downside.

What is a fund-of-funds? A fund of funds invests in a portfolio of hedge funds to provide access, diversification, risk management and due diligence benefits to investors.

How and why is leverage used by hedge funds? Although some hedge funds don’t use leverage at all, most of them do. Leverage in hedge funds often runs from 2:1 to 10:1, depending on the type of assets held and strategies used. High leverage is often part of the trading strategy and is an essential part of some strategies in which the arbitrage return is so small that leverage is needed to amplify the profit. As in any other investments, however, leverage also amplifies losses when the market direction turns out to be unfavorable.

What is due diligence? Generally, due diligence refers to the care a reasonable person should take before entering in an agreement or transaction with another party.


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    CFA

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