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Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Calculate the return on a hedge fund investment and explain the incentive fee structure of a hedge fund including the terms hurdle rate, high-water mark, and clawback. Describe various hedge fund strategies, including long/short equity, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging markets, global macro, and managed futures, and identify the risks faced by hedge funds. Describe hedge fund performance and explain the effect of measurement biases on performance measurement.


706.1. A fund of funds divides its money equally between four hedge funds who earn –3.0%, +1.0%, +11.0%, and +21.0% before fees in a particular year. The fund of funds charges "1% plus 10%" and the hedge funds charge "1% plus 20%" (due to competitive pressures this is reduced from "2% plus 20%"). The hedge funds' incentive fees are calculated on the return after management fees. The fund of funds incentive fee is calculated on the net (after management and incentive fees) average return of the hedge funds in which it invests and after its own management fee has been subtracted. Which is nearest to the return to investors in the fund of funds? (please note this is variation on Hull's EOC Question 4.17) (Source for Hull's 4.17: John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New Jersey: John Wiley & Sons, 2018))

a. 1.40%
b. 3.60%
c. 5.00%
d. 7.50%

706.2. Hedge fund fees are notoriously high, although recently the traditional "2 and 20" fee structure has been under much pressure. Clauses in fee structure agreements can help make the incentive fees more palatable for clients. In regard to these fee structure agreement clauses, each of the following is a true description EXCEPT which is inaccurate?

a. Hurdle rate is the minimum return necessary for an incentive fee to be applicable
b. High-water market requires previous losses to be recouped before an incentive fee is applicable
c. Clawback refers to investors being able to use some (or all) previous incentive fees, held in a recovery account, to offset current losses
d. Proportional adjustment clause allows the hedge fund manager, in the event of style drift, to replace the fund's benchmark, ex post, in order to reduce the funds reported tracking error

706.3. In regard to various hedge fund strategies, each of the following statements is generally true EXCEPT which statement is false?

a. Although prior to 2009, hedge fund returns lagged the S&P 500, since 2009 hedge funds have outperformed the S&P 500
b. A Distressed Securities hedge fund investor is more likely to earn an illiquidity risk premium than a typical Global Macro manager
c. A Merger Arbitrage (aka, risk arb) hedge fund investors should have a lower correlation to the broad equity markets than a typical Long/Short Equity manager
d. A Systematic Managed Futures hedge fund investor is more likely to employ technical analysis than an Emerging Markets manager

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New Member
4.2%*0.8+0.2*2%=3.76% and 6%-3.76%=2.24% what is wrong?