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P2.T8.412. Hedge funds as diversifiers and agents

Nicole Seaman

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AIMs: Describe the historical portfolio construction and performance trend of hedge funds compared to equity indices. Describe market events which resulted in a convergence of risk factors for different hedge fund strategies, and explain the impact of such a convergence on portfolio diversification strategies. Describe the problem of risk sharing asymmetry between principals and agents in the hedge fund industry. Explain the impact of institutional investors on the hedge fund industry and assess reasons for the growing concentration of assets under management (AUM) in the industry.


412.1. You receive a general solicitation from a hedge fund, which is now possible under the 2012 JOBS Act. The fund advertises its style as a long/short equity manager. However, you are skeptical of each of the solicitation's claims. In fact, each of the following claims from the long/short equity manager is dubious or unlikely EXCEPT which is the MOST PLAUSIBLE or MOST LIKELY?

a. As a long/short equity manager, we are located in an rare (uncommon) style with few competitors who also employ a long/short strategy
b. As a long/short equity manager, we are non-directional with virtually no exposure to the stock market
c. As a long/short equity manager, you might find us long small cap stocks and emerging markets but short large cap stocks
d. As a long/short equity manager, we try to avoid the idiosyncratic risk that attaches to so-called "stock pickers" in favor of acknowledging that markets are efficient

412.2. According to Fung and Hsieh, "An important feature that attracts investors to the hedge fund industry is the variety of strategies hedge fund managers deploy and the diversity of assets to which these strategies are applied." Which of the following best summarizes the historical evidence with respect to the ability of hedge funds to provide diversification benefits?

a. With few exceptions, most hedge fund strategies have successfully provided high diversification benefits and low correlation through all recent, major market events
b. Although there has rarely been a problem on the liability (funding) side of the balance sheet, diversification among risk factor exposures on the asset side has rarely been achieved in practice
c. Managers who successfully diversified their risk factor exposures on the asset side, in turn, guaranteed their diversification on the liability (funding) side and thrived during major market events
d. Most strategies employ leverage and are vulnerable to forced liquidation, a shared problem on the liability side of the balance sheet, and and there is no easy and complete solution

412.3. Which of the following is the best summary of the primary principal-agent risk (or problem) in the hedge fund industry, according to Fung and Hsieh?

a. Although "clearly of academic interest," there is neither credible evidence, nor a plausible narrative in support of, a realistic principle-agent problem in the hedge fund industry
b. The principle-agent risk arises due to the incentive fee structure and the high water mark (HWM), but can be mitigated by agents (fund managers) who invest a sizable amount of their own wealth in the fund
c. The principle-agent risk arises due to the fact that hedge fund managers have more information about the fund's investments than managers, and there is no easy solution to this principle-agent problem because the principals are not full-time investors themselves
d. The principle-agent risk arises due to the fact that the hedge fund manager, who charges a management fee as a percentage of assets under management (AUM), wants to grow the size of the firm rather than outperform, but this can be addressed simply by avoiding big funds in favor of small funds

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