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Characteristics of Hedge Funds

2. The term „hedge fund“ applies to a fund that is privately managed, limited to a select group of
investors, and is subject to a very low level of regulation.
3. The private nature of hedge funds and the selectivity of clients lead to low regulation, making
hedge funds distinct from mutual funds, which are heavily regulated, publicly traded, and
available to all investors.
4. Hedge funds usually focus on absolute return, as opposed to mutual funds which focus on the
return relative to a benchmark.
5. Hedge funds pay a fee to the manager as a percentage of profit or asset appreciation, while
mutual funds usually pay a percent of assets under management to the manager.
6. Hedge funds often have redemption limitations which require a minimum investment period
and some pre-specified amount of warning time before an investor can withdraw capital.
7. Hedge funds using the tactical investment style take positions designed to benefit from
movements of entire markets such as bonds, equities, currencies, and commodities.
8. There are two main sub-styles in the tactical investment style: global macro investing and
commodity trading advisors.
9. The global macro strategy makes opportunistic tactical moves in global markets. Each fund is
usually concentrated in one area and may use a variety of strategies (e.g., derivatives and
10. Commodity trading advisors, or CTAs, generally trade listed financial futures and commodities
for their clients.
11. CTAs may be discretionary traders or systematic traders. To make trading decisions,
discretionary traders use fundamental and technical analysis and their own personal trading
experience, while systematic traders rely more on historical relationships incorporated into
computer programs.
12. The equity long/short style refers to taking both long and short positions in equities. Most
funds using this style have a net long exposure to stocks, but some funds will take
comparatively large short positions.
13. The equity long/short style has three style categories:
• The dedicated short selling style.
• The emerging markets style.
• The market timer style.
14. The dedicated short selling style only takes short equity positions.
15. The emerging markets style attempts to gain from the low level of information and
idiosyncratic movements associated with those markets.
16. The market timer style takes positions based upon short-lived factors.
17. Event-driven styles generally focus on securities associated with companies where a major
event like bankruptcy, a merger, or a spin-off will occur.
18. Three general event-driven style categories are:
• The distressed securities style.
• The merger arbitrage (or risk arbitrage) style.
• The event-driven multi-strategy style.
19. The distressed securities style focuses on assets of distressed companies where the manager
thinks the assets are severely undervalued.
20. The merger arbitrage style focuses on potential profits associated with a merger or acquisition.
21. The event-driven multi-strategy style can use the distressed securities style and/or the merger
arbitrage style. It can use both at the same time or switch back and forth. The style also
includes the use of other strategies such as investing in micro-cap stocks.
22. The relative arbitrage style takes positions in two securities, usually with an identifiable
relationship such as convertible bond and the associated stock, that are mispriced relative to
each other. The goal is to gain when the securities converge to their appropriate values over
23. Arbitrage is the process of the two securities converging to their appropriate market value.
24. The convertible arbitrage style involves taking a long position in a convertible bond and selling
short the associated stock.
25. The main source of return of the convertible arbitrage style comes from a decline in the price
of the stock. The main risk is from the possibility of the stock increasing in value, but this is
hedged with the bond’s embedded option, which is generally believed to be undervalued.
26. There are many fixed income arbitrage strategies. To earn profits, they can use tax loopholes,
different laws and taxes policies around the world, projected changes in yield curves around
the world, and other factors. Often, the manager will create the position and take offsetting
positions to neutralize interest-rate risk.
27. The equity market neutral style uses a long/short strategy and has a stated goal of eliminating
market risk (i.e., reducing beta to zero), with offsetting long and short positions.
28. Usually, an equity market neutral manager uses pair trading, which involves buying one stock
that is undervalued and one that is overvalued, in proportions that result in a beta equal to
zero. The main source of return comes from corrections of the asset prices.
29. In contrast to the equity market neutral style, the equity long/short style takes short positions
but does not explicitly try to set market risk equal to zero.
30. The index arbitrage style generally attempts to exploit mispricings between an index and its
associated derivatives.
31. The mortgage-backed securities arbitrage style seeks to earn a profit from mispricing of these
assets, relative to Treasury securities, based upon their uncertain credit quality and
prepayment risk.
32. A fund of funds will allocate capital to different managers of hedge funds who may or may not
use the same style. The goal is to diversify across managers and/or styles.
33. In contrast to a fund of funds, a multi-strategy fund tends to have the capital under the
management of one person or office. It may use many styles, which can provide some
diversification, but it may focus more on trying to time the styles.
34. High net worth individuals are currently the main source of the assets under management for
hedge funds.
35. Institutions are expected to be a major source of capital for hedge funds in the future, but
individuals will continue to supply capital.
2. Measuring Return

1. The lack of transparency in the hedge fund market is caused by several factors including the
fact that they are privately organized, regulations restricting hedge fund marketing, and
managers deliberately keeping their strategies a secret.
2. The trend towards hedge fund self-institutionalization is the result of growth in the industry,
increased interest from institutions like pensions, and an attempt to reduce the likelihood of
further government regulation.
3. Position transparency means revealing the positions in a hedge fund, and it often includes a
great deal of information. Risk transparency is achieved by revealing a summary of exposures
to various risks and is more concise than position transparency.
4. The goal of equalization is to make sure the investors in the fund pay an appropriate portion of
the manager’s fee for the measurement period.
5. The main reason behind equalization is the possible distortions and inequitable fee payments
that can be caused by investors contributing capital during the measurement period.
6. In the absence of adjustments, each investor would pay a portion of the inventive fee simply
based upon the number of shares owned.
7. The free ride syndrome occurs when an investor buys shares in the middle of a measurement
period at a time when the shares have declined. The shares eventually recover and exceed
their beginning period value, and there are no fee adjustments. In such a case, the portion of
the incentive fee paid by the middle-of-period investors earned from the recovery of the share
8. Onshore funds are usually closed-ended and offshore funds tend to be open-ended. Being
open-ended introduces the need for adjustments in the payment of fees.
9. The multiple share approach is the practice of issuing a new class of shares for each new
inflow of capital to a hedge fund.
10. The main advantage of the multiple share approach is being able to keep track of how much
of the incentive fee each investor must pay. The main disadvantage is the fact that the number
of classes of shares can become quite large and difficult to track individually.
11. The equalization factor approach involves setting up a special account to be associated with
each inflow of cash that occurs in the middle of a measurement period. The account
represents a fee adjustment to the middle-of-period investor’s portion of the management fee.
12. Crystallization occurs at the end of the accounting period when there is a calculation of any
remaining equalization factors attributable to shareholders when the manager is paid the
incentive fee.
13. The equalization approach allows the NAV per share to be calculated as the gross asset value
minus the incentive fee earned at any given point.
14. The simple equalization approach records the different net asset values for each investor
based upon the time of the investment. At the end of the period, it assigns the lowest NAV of
all the shares to each share and makes up the differences in NAVs by issuing additional,
fractional shares to each investor who purchased shares at the higher NAVs during the period.
15. The simple equalization approach differs from the multiple-share approach in that the former
consolidates all its shares to one NAV at the end of each measurement period. The multiple-
share approach continues to record each series separately from period to period.
16. In a formula , the net return (holding period return) is:

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������ �

The sample gross return is:

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17. A compounded return for n periods is:

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18. Gross returns are computed before deducting management fees and other expenses. Net
returns have had management fees and other expenses deducted.
19. The list of approaches to assign prices to determine net asset value includes the average
quote, the average quote with top and bottom removed, a median quote, and a subjective
judgment quote.
20. Valuation of illiquid assets usually includes a liquidity adjustment.
21. Cash accounting only records income when received and expenses when paid. Accrual
accounting matches income with expenses.
22. Trade date is the day the manager executes the order. Settlement date is when the cash
transfers to settle the executed order.
23. Let N equal the number of sub-periods in a year, then for i sub-periods:
���������� ������ � �� � ������ � ��
24. When calculating the performance of several funds, an equal weighting approach is equivalent
to a simple average of the returns of the funds.
25. The equal weighting approach is essentially a specific case of a weighted average that
assigns each fund return a weight of 1/N, where N is the number of funds.
26. An asset weighting approach for a portfolio of funds involves weighting each return by the ratio
of the assets in the respective fund to the sum of all the assets in the funds being analyzed.
27. Multiplying the individual fund returns by their respective weights and summing the resulting
weighted returns gives the aggregate return.
28. An arbitrary weight approach generally involves choosing weights in an arbitrary way that may
vary over time, with one caveat that the weights must sum to one.
29. The median fund return is the middle return of the sorted returns of a group of funds being
30. The continuously compounded return is rt�t�i� � ln(��Rt�t�i)��or simply the natural logarithm of
the gross return.
31. If a fund increases in value from $100 to $130, the continuously compounded return is
ln(�30/�00)�0.2624, or 26.24%.
32. To annualize a continuously compounded return, simply multiply the return by N/i, which is the
number of periods in a year divided by the number of sub-periods over which the return was

���������� ������ � � � ln �� � ������ �

33. Continuous compounding over several periods is simply the difference of the logarithms of the
ending NAV and the beginning NAV:
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3. Return and Risk Statistics

1. A relative frequency histogram is a graph of the relative frequencies (percent of observations)

falling in mutually exclusive data intervals. Steps involved in creating relative frequency
histograms are:
• Set up mutually exclusive intervals.
• Assign each observation to one interval.
• Calculate the relative frequency (percentage of observations) within each interval.
• Plot the histogram charting the relative frequencies for each interval.
2. The arithmetic average return is the simple average return computed over a prespecified time
period. The formula for the arithmetic average return equals the sum of the periodic returns
divided by the number of periods over which the sum is computed.
3. The geometric mean return is the compound average return divided over a prespecified time
4. The geometric return accounts for compounding. The arithmetic return does not account for
compounding. The geometric mean return will always lie below the arithmetic average return
and the difference between the two statistics widens as the data series becomes more
5. In the case of continuously compounded returns, the geometric mean return simply equals
, where is the average continuously compounded return.
6. The median is the middle number within a ranked data series. The median provides a better
measure of the central tendency of a data distribution in the presence of outlier (or extreme)
7. The average gain is the arithmetic average return computed over all periods in which the fund
manager earned a positive return. Similarly, the average loss is the arithmetic average return
computed over all periods in which the fund manager earned a negative return. The gain to
loss ratio equals the average gain return divided by the average loss return. A positive ratio
indicates that, on average, the fund manager’s average gains outpaced the average losses.
8. Performance rankings based solely on average fund returns are misleading because they
ignore the risks undertaken by each fund. Risk and return are inversely related. Therefore, low
risk funds will rank near the bottom based on long-term average rate of return.
9. Many definitions of risk exist. The common factors of all risk statistics are that they focus on
uncertainty and the chance of disappointing outcomes.
10. The range is the difference between the minimum and maximum values in a data distribution.
The range is not usually a good indicator of risk because it relies solely on two data points (the
extreme observations) and ignores all other intermediate observations.
11. A percentile is the percentage of observations in a data series that lies below a particular
value. For example, the 5 percentile return equals the return below which the portfolio
performed 5% of the time, and above which the portfolio performed 95% of the time.
12. The variance measures the extent to which a fund’s performance deviates from its mean
13. Volatility is measured by the fund’s standard deviation, which equals the square root of the
variance of returns.
14. The formula for the variance for sampled data equals the sum of squared deviation of the
portfolio return from its sample mean divided by the number of sampled returns less one. The
formula for the variance derived from the entire population equals the sum of squared
deviations of the portfolio return from its population mean divided by the total number of
15. The variance formula using simple returns does not account for compounding effects. Instead,
the variance should be calculated using continuously compounded returns. The volatility that
accounts for compounding equals e raised to the power of the standard deviation of
continuously compounded returns less one.
16. The annualization procedure often employed for volatility ignores the effects of compounding.
Therefore, the calculation of the annualized volatility is inconsistent with the calculation of the
annualized return.
17. The researcher must balance the need for sufficient number of observations to derive reliable
volatility estimates with the reality that volatility is not constant over time.
18. Skewness refers to the extent to which the distribution of data is not symmetrical about its
mean. The tail of the distribution is elongated to the right for positively skewed data and is
elongated to the left for negatively skewed data. Positively skewed distributions have more
positive outliers than negative outliers. Negatively skewed distributions have more negative
outliers than positive outliers.
19. Kurtosis refers to the degree of peakedness in the data distribution. A distribution is said to be
leptokurtic if it has a peak that extends above that of a normal distribution, and has tails that
are fatter than those of a normal distribution. In contrast, a distribution is said to be platykurtic
if it has a peak that lies beneath that of a normal distribution, and has tails that are thinner
than those of a normal distribution.
20. The Beta-Jarque statistic is used to test data for departures from the normal distribution. The
formula for the statistic is:
where S is the skewness, and K is the kurtosis for the sampled data. If the data follow a
normal distribution, S equals 0 and K equals 0, and the Beta-Jarque statistic also equals zero.
21. The Beta-Jarque statistic follows a chi-square distribution with two degrees of freedom. The
null hypothesis that the data follow a normal distribution is rejected if the Beta-Jarque statistic
exceeds the critical value (usually the 95 percentile of the chi-square distribution with two
degrees of freedom).
22. Drawbacks of using volatility (standard deviation) as the measure of risk include:
• Asymmetric returns: the standard deviation is high for funds with many more
abnormally high returns versus abnormally low returns. Yet, few investors would
equate the abnormally good performance with risk.
• Benchmark: the standard deviation examines the volatility around the sample mean
return. Yet many investors equate risk with volatility around a target return such as a
minimum acceptable return or a benchmark return, rather than the sample mean
• Risk aversion: the standard deviation weights positive and negative surprises equally.
Yet, most investors dislike negative surprises more than they like positive surprises.
23. Downside risk differs from volatility risk by focusing solely on returns that fall below a pre-
specified target return. Therefore, downside risk differs from traditional volatility risk in two
ways. First, downside risk focuses solely on negative surprise outcomes. In contrast, volatility
risk uses all returns, positive and negative surprises. Second, downside risk uses a
customized reference point or target return, #. In contrast, volatility risk uses the historical
mean return for the fund.
24. Semi-deviation equals the volatility of returns that fall below the historical mean return and is
used as a measure of downside risk.
25. Below-target semi-deviation equals the volatility of returns that fall below the returns a for pre-
specified benchmark, and is also used as a measure of downside risk. The below-target semi-
variance equals the square of the below-target semi-deviation.
26. Other measures that shed light on the riskiness of the fund are downside frequency, gain
standard deviation, and loss standard deviation. The downside
Frequency equals the number of negative surprise occurrences, indicating how often the fund
underperformed the target. The gain standard deviation equals the volatility of all positive
returns around the average positive rate of return, indicating upside volatility. The loss
standard deviation equals the volatility of all negative returns around the average negative rate
of return, indicating downside volatility.
27. Shortfall probability equals the chance that the fund’s return will be less than a pre-specified
target return.
28. Value at risk (VaR) is the maximum percent loss, equal to a pre-specified “worst case”
quantile return (typically the 5 percentile return). In contrast, expected shortfall is the mean
percent loss among the q-quantile worst returns.
29. Drawdown equals the percentage decline in asset value from its previous high.
30. Several drawdown statistics are used in practice. The maximum drawdown is the worst
percent loss experienced from peak to trough over a specified period of time. The
uninterrupted drawdown measures the duration of the consecutive loss periods as well as the
cumulative loss over the uninterrupted loss period. The drawdown duration is the amount of
time needed to totally recover the drawdown.
31. Drawdowns are more easily understood than volatility risk measures, but must be used
cautiously. In particular, maximum drawdowns are larger for assets that are valued more often
and increase with the time period examined, which place long time managers of daily marked-
to-market assets at a disadvantage.
32. Funds are often evaluated relative to pre-specified benchmarks, such as those defined below:
• Capture indicator: ratio fund average return to the benchmark average return.
• Up capture indicator: fund average up percent gains divided by benchmark average
up percent gains.
• Down capture indicator: fund average down percent gains divided by benchmark
average down percent gains.
• Up number ratio: number of periods in which a positive return for the fund and
benchmark coincided divided by the total number of positive returns for the
• Down number ratio: number of periods in which a negative return for the fund and
benchmark coincided divided by the total number of negative returns for the
• Up percentage ratio: number of periods in which the fund outperformed the
benchmark during up periods for the benchmark divided by the total number of
positive returns for the benchmark.
• Down percentage ratio: number of periods in which the fund outperformed the
benchmark during down periods for the benchmark divided by the total number of
negative returns for the benchmark.
• Percent gain ratio: number of positive returns for the fund divided by the number of
positive returns for the benchmark.
• Ratio of negative months over total months: number of negative monthly returns for
the fund divided by the total number of sampled months.
33. The beta of a hedge fund measures the sensitivity of its returns to changes in the benchmark
return. Beta does not measure the total risk of the fund: it measures only that part of the fund’s
risk that is related to the benchmark, often called market or systematic risk.
34. Tracking error measures the extent to which the portfolio’s returns deviate from the
benchmark returns over time. Therefore, tracking error quantifies the uncertainty (risk)
regarding deviations of the portfolio return from the benchmark return. A low tracking error
indicates that the fund performance closely resembles that of the benchmark. Several tracking
error statistics are used in practice, including the root mean difference from the benchmark,
the standard deviation of differences from the benchmark, and the mean absolute deviation
from the benchmark.
4. Risk-Adjusted Performance Measures

1. The Sharpe ratio measures the portfolio’s excess return per unit of (total) risk, determined by
the standard deviation of portfolio returns: .
2. The information ratio (IR) measures the performance of a portfolio relative to a prespecified
benchmark: . The numerator of the IR can also be viewed as the zero investment
hedge fund return on a long/short strategy that takes a long position in Portfolio P and an
offsetting short position in the benchmark.
3. Various tests of significance for differences in Sharpe ratios are often used. The Jobson and
Korkie test examines differences in Sharpe ratios between two portfolios, assuming normality
of portfolio returns. In contrast, the Gibbons, Ross, and Shanken test examines differences in
Sharpe ratios between a managed portfolio and the mean-variance efficient market portfolio.
Finally, the Lo test relaxes the distributional assumptions on the portfolio returns, incorporating
characteristics such as serial correlation and mean reversion.
4. The CAPM provides an equilibrium relationship between required returns for assets and their
betas: required return = . Therefore, according to the CAPM, the risk
premium for any asset equals . The graph of the CAPM is called the Security
Market Line, with intercept equal to the risk-free rate, , and slope equal to the market risk
premium, .
5. The Jensen alpha equals the difference between the return earned on the portfolio and the
portfolio’s CAPM required return.
6. The Treynor ratio equals portfolio excess return divided by beta.
7. The Treynor ratio differs from the Sharpe ratio by using the portfolio beta as the appropriate
measure of risk (in contrast to the Sharpe ratio that uses the standard deviation). The ratio of
the portfolio’s alpha to its beta equals the difference between the Treynor ratios for the
managed portfolio and the market index.
8. The M portfolio performance statistic compares the rate of return performance of a managed
portfolio versus the market portfolio, after controlling for differences in standard deviations.
The M measure applies leverage or deleverage to the managed portfolio (in order to match
the risk of the market portfolio).
9. Both GH1 and GH2 performance measures relax the assumption that the maturity of the risk-
free asset matches the portfolio evaluation period. Therefore, the maturity of the treasury
security may exceed the length of the evaluation period, exposing the treasury security to
interest rate risk. The end result is that the GH measures are derived using the curved
opportunity sets connecting the Treasury bill with the managed portfolio or with the market
portfolio. To control for differences in risk, the GH1 measure applies leverage/deleverage to
the market portfolio, whereas the GH2 applies leverage/deleverage to the managed portfolio.
10. The Sortino ratio measures rate of return performance for a portfolio, relative to its downside
risk. In contrast, the upside-potential ratio examines the expected upside return for a portfolio
(above the minimum acceptable return benchmark), relative to its downside risk.
11. Both the Sterling ratio and the Burke ratio evaluate rate of return performance relative to
drawdowns (percent losses) experienced by the portfolio. The drawdown measure differs
between the two ratios. The Sterling ratio uses the average extreme drawdown (or most
extreme drawdown), whereas the Burke ratio uses the square root of the sum of all drawdown
12. The return on value-at-risk, or RoVaR, equals the mean return earned on the portfolio divided
by the portfolio’s value-at-risk (in absolute value).
5. Databases, Indices, and Benchmarks

1. Self-selection bias results from the fact that managers voluntarily submit their performance
data to database vendors. Since funds with good track records and smaller funds with express
capacity and good results have an incentive to report (they cannot otherwise market or
advertise their results), an upward bias in the performance data results.
2. Sample selection bias results when database vendors impose inconsistent criteria across
vendors with respect to database inclusion (such as asset size and track record restrictions).
This results in incomplete samples with widely varying fund membership among different
database vendors.
3. Survivorship bias results when the history of dead, merged, or otherwise nonreporting funds is
excluded from the historical set of returns in the database, which results in an upward bias in
the database’s reported results.
4. Backfill bias occurs when a fund is allowed to include its historical returns upon its inclusion in
a database. The upward bias is estimated at 1.2% to 1.4% for databases that allow this
5. Illiquidity bias results when funds hold infrequently priced assets. Subjectivity in the valuation
process (i.e., the manager, rather than the market, assigns an asset its value) tends to smooth
returns and understate volatility (thus overstating risk-adjusted return measures).
6. The benefits of hedge fund indices are that they can provide a representation of the underlying
universe of hedge funds, provide correlation estimates as an input into an optimization
process, allow the investor to compare the risk and return trade-offs of various trading
strategies, provide the basis for a passive investment vehicle, and give the investor the ability
to compare individual hedge fund managers against an index of all managers.
7. The difficulties in constructing an effective index are that the indices will also contain the
databases’ biases, and classification may be inaccurate.
8. Characteristics of a well-constructed index include the following: the index fund is transparent
representative, capitalization weighted, investable, timely, and stable over time.
9. The key characteristics of the various hedge fund databases are as follows:
• ABN AMRO – Asian hedge funds, equal weighted, reporting restrictions (sample
selection issues).
• Altvest – CaLPERS uses this database which tracks 2,000 plus hedge funds and 14
indices. Funds may show up in several sub-indices.
• MAR/CISDM – has tracked data on managed futures since 1979 and on the hedge
fund industry since 1994. Now owned by the University of Massachusetts-Amherst.
Academic database of choice.
• CSFB/Tremont – indices start in 1994 and use 3,000 hedge funds from the TASS
database (fund of funds and managed accounts are excluded). Funds must have $10
million in assets under management and audited financial statements, and they must
meet requirements on disclosure and transparency. Indices are rebalanced monthly
with quarterly manager revisions. CSFB/Tremont created a series of investable
indices in 2003. They are the only capitalization-based index provider.
• Evaluation Associates Capital Markets – nontransparent, based on a small sample
size. EACM100 is the master index. They also have five broad strategy indices and 13
sub-strategy indices with data starting in 1990. Equally weighted, non-audited
performance data are provided by 100 participating hedge funds.
• Hedge Fund Research – pure indices with minimum bias problems. HFR has 37
equally weighted monthly performance indices (onshore and offshore). Returns are
net of fees and free of survivorship bias after 1994. No minimum asset size or track
record is necessary. They maintain dead fund history. In 2003, Hedge Fund Research
published one composite and eight investable indices (rebalanced quarterly).
• Capital Group (Tuna indices) – produces 32 equally
weighted indices from a database of 4,000 onshore and offshore hedge funds. Self-
selection, survivorship biases are present.
• Hennessee – produces 23 equally weighted indices and four composites based on a
sample of 500 hedge funds from a database of 3,000 funds. Restrictions of index
inclusion include: (1) a minimum of $100 million in assets under management or
greater than $10 million and a 1-year track record, and (2) satisfy reporting
requirements. Indices retain the historical performance of dead funds and include
several funds that are closed to new investors.
• Invest Hedge/Asia Hedge/Euro Hedge – HFI does not manage money or provide
investment advice. Data goes back to 2000 for HFI’s European hedge fund indices
and to 2001 for its Asian hedge fund indices.
• LJH Global Investments – small sample size, investable indices. LJH publishes 16
equally weighted indices of 25 to 50 hedge funds.
• Morgan Stanley Capital International – created a database of over 1,500 funds in
2002 and created premier hedge fund classification system based on the manager’s
investment process, the asset classes used, geographic location of investments, and
secondary classifications. Three composites based on asset size including broad
(greater than $15 million), core (greater than $100 million), and small ($15 million to
$100 million).
• Standard & Poor’s – equally weighted and primarily investable indices cover nine
styles and contain only 40 funds.
• ZCM – Zurich Capital Markets has failed at several attempts to create hedge fund
indices based on style while simultaneously offering investors fund of funds that would
track the indices’ performance.
• Van Hedge Fund Advisors International – comprehensive database of over 5,000
funds. Tracks 14 strategies and one global index based on a sample of 750 offshore
and onshore hedge funds.
10. The intuition of the EDHEC index is that each of the existing indices represents a sample of
the underlying universe with some noise created by database biases. By combining the
available indices and using PCA, the resulting index is a pure form index for the underlying
universe without bias problems.
11. Three key reasons why performance benchmarks are important are that they:
• Help measure the investment performance of hedge fund managers.
• Provide clients and trustees with a reference point for monitoring performance.
• Modify the behavior of portfolio managers who drift away from their investment
12. The three reasons why the S&P 500 would be a poor hedge fund benchmark include the
• Inconsistent holding periods and market exposures of managers versus the S&P 500.
• Hedge funds typically employ leverage and short sales.
• Hedge funds typically invest in shares of firms and asset classes not included in the
S&P 500.
13. The benefits of the relative peer group benchmarks are that they look at the performance of
other practitioners, reflect the differences or similarities between managers, and take into
account the transaction and trading costs. The drawbacks are that they suffer from selection
and survivorship bias, lack overall representativeness, and are not a viable passive
investment strategy. Peer groups are not useful to assess the performance of a manager in
14. The essential elements of a manager benchmark are that it be unambiguous, investable,
appropriate, reflective, measurable, and specified in advance.
15. The following are the four properties that an ideal benchmark should possess: (1) simple to
understand, (2) replicable, (3) comparable, and (4) representative of the underlying market.
6. Covariance and Correlation

1. A scatter plot is a graph of paired observations fort wo variables, illustrating the relationship
between the variables.
2. The covariance is a statistic used to measure the relationship between two variables. The
covariance ranges from negative infinity to positive infinity. A positive covariance indicates a
positive relationship, a negative covariance indicates a negative relationship, and a zero
covariance indicates no relationship.
3. The formula for the sample covariance is:

4. The variance-covariance matrix is a square table arranged in a fixed number of rows and
columns that report variances and covariances. Variances are reported down the diagonal and
covariances are reported in the off diagonal cells. The covariance between variables i and j is
reported in Row i and Column j.
5. The covariance is unbounded, ranging from negative to positive infinity, with the actual
magnitude of the covariance providing little insight into the strength of the relationship. To
correct this problem, it is common to scale the covariance by the product of the standard
deviations of the two variables. By scaling the covariance, we derive the correlation.
6. The correlation between two variables (also known as the Pearson product-moment
correlation coefficient) equals:

7. A correlation matrix is a square table arranged in a fixed number of rows and columns,
conveniently providing correlations for different pairs of variables.
• The correlation between variables or ranks i and j, is reported in Row i and Column j.
• All correlations down the diagonal will equal 1.
8. The Spearman rank correlation equals the Pearson correlation of the variable rankings. The
Spearman rank correlation is particularly appropriate for data series that are not normally
9. To calculate the Spearman rank correlation, convert each observation to a rank with the
lowest observation equaling one and then use the following formula:

10. Geometry can be used to illustrate the effects of correlation on portfolio risk. Portfolio risk can
be measured by the length of a vector. A leverage overlay is perfectly positively correlated
with the original portfolio, causing the new and old portfolio to lie at a zero degree angle to
each other. In contrast, a hedge overlay is perfectly negatively correlated with the original
portfolio, causing the new and old portfolio to lie at a 180 degree angle to each other. And, the
risk of the portfolio comprising uncorrelated assets equals the length of the hypotenuse of a
right triangle.
11. The correlation estimate measures the strength of the linear relationship between two
variables, but it does not necessarily imply a causal relationship between the two variables.
12. Correlation measures the direction and strength of the linear relationship between two
variables. It does not measure the strength of non-linear relationships.
13. A spurious relationship refers to an incorrect inference drawn from an observed correlation,
and is most often made when correlations are high between variables that have no logical
14. An outlier is defined as an extreme or abnormal observation that is not representative of the
majority of observations in the sample. Outliers cause the correlation to move toward zero,
which incorrectly implies a lack of relationship between the variables. The researcher should
attempt to use robust estimation methods that identify and diminish the weight or importance
of outliers in the correlation calculation.
15. The partial correlation is the correlation between two variables after controlling or removing
the effects of other related variables.
16. Sampling error refers to the difference between a sample statistic and the corresponding
population parameter that it is trying to estimate. Sampling error declines as the sample size
17. A confidence interval is an estimated range within which the population parameter is likely to
be contained. Confidence limits refer to the lower and upper bounds of the confidence level.
18. Statistical significance refers to the probability that a relationship observed in a sample did not
happen by chance. If the estimate is statistically significant, then the estimate is reliable.
19. The correlation confidence interval is the range within which the population correlation is likely
to be found.
20. A correlation estimate is statistically significant if its estimated confidence interval does not
include zero.
21. Heteroscedasticity refers to a data series characterized by a nonconstant dispersion (or
variance), which may cause the correlation estimate to be biased downward.
7. Regression Analysis

1. The general equation underlying any regression equals the sum of predictable and
unpredictable components.
2. The true regression model is unknown. Instead, we must rely on regressions derived from
estimated models.
3. Primary problems encountered by regression include:
• The selection of appropriate independent variables
• The use of appropriate estimation methods
• The evaluation of the quality of the estimated model
4. Linear regression is a statistical technique used to explain the linear relationship of the
dependent variable with one or more predictor or independent variables. The regression
equation is the mathematical representation of the linear relationship.
5. The use of sampled data introduces many errors into the regression estimation process. The
most common sampling errors include:
• Recording errors: errors recording the data in the database
• Non-synchronous pricing: last trades of the day not transacting at exactly the same
• Liquidity premiums: not all assets can be bought and sold with the same ease
• Discreteness: increments used to price assets may not represent true values
6. Linear regression should be viewed as a first order approximation of reality because, in reality,
most relationships are not perfectly linear.
7. The regression error term equals the difference between the observed and estimated values
of the dependent variable. Large errors indicate an inferior or useless regression; small errors
indicate a superior or useful regression.
8. Ordinary least squares (OLS) is a statistical technique that derives a regression line that
minimizes the sum of squared regression errors.
9. Desirable properties of OLS include:
• The regression errors remain as small as possible
• The regression will pass through the sample means of the dependent and
independent variable
• The errors are uncorrelated with the independent variable and with the estimated
dependent variable
• The estimates of the intercept and slopes are the best linear unbiased estimates
10. The slope coefficient equals the average change in the dependent variable for every 1-unit
change in the independent variable. The formula for the slope coefficient estimate is ,
where sx,y is the sample covariance between the dependent and independent variables (Y and
X, respectively), and is the sample variance for the independent variable.
11. The intercept is the point of intersection of the regression line with the Y-axis. The formula for
the intercept estimate is .
12. The multiple R is the correlation between the realized values and the predicted values of the
dependent variable.
13. The R-square is the fraction of the dependent variable’s variance that is explained by the
regression. The R-square equals the square of the multiple R, and is also equal to the
regression sum of squares divided by the total sum of squares.
14. The standard error of the estimate is the standard deviation of the regression residuals. A
large standard error indicates that the scatter around the regression line is large, suggesting
the regression is inferior.
15. ANOVA, or analysis of variance, refers to the decomposition of the variance of the dependent
variable into explained and unexplained components.
16. The F-statistic is the test statistic used to test the overall significance of the regression:
H0: all slopes equals zero
HA: not all slopes equal zero
The formula for the F-statistic equals the ratio of the mean explained variation to the mean
unexplained variation.
17. A p-value equals the probability that the null hypothesis is correct. The null hypothesis, H0:
slopes = zero, is rejected if the p-value is less than the significance level used for the test
(typically 5%).
18. The t-statistic for the slope estimate equals the slope estimate divided by its standard error.
The null hypothesis, H0: slope = 0, is rejected if the t-statistic exceeds its critical value (which
equals 1.96 for a large sample based on a 5% level of significance).
19. A confidence interval is the reasonable range within which the true unknown parameter (e.g.
slope) is likely to be found. The null hypothesis, H0 = 0, is rejected if the confidence interval
does not contain the hypothesized value (0).
20. Several difficulties limit the usefulness of regression to derive accurate forecasts for the
dependent variable. These difficulties include unpredictability of the independent variables,
instability of regression parameters, out-of-sample predictions, and spurious relationships.
21. Regression is often used to predict the dependent variable. Using a simple linear regression,
the predicted value for Y equals , in which and are the estimated intercept and
slope (from past data), and X is the predicted value for the independent variable.
22. Multiple linear regression refers to a linear regression of a dependent variable against multiple
independent variables.
23. In contrast to the R-square, the R-adjusted considers the number of independent variables
used in the regression. The formula for the R-adjusted equals:

24. To test the overall significance of a multiple regression, the F-statistic is used:
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25. Omitted variable bias is present when independent variables that should be in the model are
omitted. The consequences of this bias depend on the correlation between the included and
omitted variables. If the correlation equals zero, then the intercept estimate is biased and the
regression residuals might deviate from the normal distribution. If the correlation equals 1,
then all the parameters are adversely affected (intercept and slope estimates are biased, and
regression residuals might be non-normal).
26. Extraneous regression variables refer to regressions that include irrelevant independent
variables. If the extraneous variable is uncorrelated with the relevant independent variables,
then there is no bias. On the other hand, if the extraneous X variable is correlated with the
relevant X variables, then the standard errors of the parameter estimates will be inflated,
causing the t-statistics to fall.
27. Multicollinearity refers to the violation of a regression assumption that all the independent
variables are uncorrelated with each other. Multicollinearity causes the intercept and slope
standard errors to be biased upward, and t-statistics to be biased downward.
28. Heteroscedasticity refers to the violation of a regression assumption that the variance of the
regression errors is constant across all observations. There are two common corrections for
• Use a different specification for the model (different X variables, or perhaps non-linear
transformations of the X variables)
• Apply a weighted least squares estimation method, in which OLS is applied to
transformed or weighted values of X and Y. The weights vary over observations,
depending on the changing estimated error variances.
29. Serial correlation refers to the violation of the regression assumption that the regression errors
are uncorrelated across observations.
30. The Durbin-Watson test refers to the test of the hypothesis that the regression errors are not
serially correlated. For a large sample, the Durbin-Watson test statistic equals approximately
2(1-corr), where corr is the correlation between successive regression residuals. The null
hypothesis of no serial correlation will usually be accepted if the Durbon-Watson statistic lies
between 1.5 and 2.5.
31. Non-linear regression refers to regressions in which the relationship between the dependent
and one or more of the independent variables in non-linear. A model in which the effects of the
independent variable on the dependent variable change over time will produce a curved
relationship between the dependent and independent variable. A typical example is the
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32. Transformations refer to non-linear modifications (e.g., ratios, trigonometric functions, and
logarithms) to the original data.
33. Stepwise regression refers to a method in which independent variables are selected
sequentially based on incremental explanatory power.
34. The backward elimination stepwise regression approach begins by including all independent
variables chosen to be analyzed by the researcher. Each independent variable is then
evaluated based on its ability to explain the dependent variable. The variable that explains the
least (smallest slope coefficient t-statistic) is eliminated, and the process is repeated until all
variables significantly contribute to the explanatory power of the regression.
35. The forward selection stepwise regression approach begins with no independent variable. The
first variable added to the model is the one with the highest slope t-statistic. Then, other
variables are added sequentially, depending on the magnitude of their t-statistics.
36. Hierarchical multiple regression uses similar statistical tests as those applied in stepwise
regression, except that the researcher, not the computer, selects the order in which the
independent variables are sequentially tested and added to the model.
37. In contrast to simple linear regression, non-parametric regression makes very few
assumptions about the behavior of the data (normality of the error term, homoscedasticity of
the errors, no serial correlation among the errors, etc.) or about the exact functional form of
the relationship between Y and X. Non-parametric regression is a data smoothing method.
8. Asset Pricing Models

1. Dimension reduction is taking a large amount of data and condensing it into a much smaller
number of variables or factors, without losing the information content of the data set.
2. Factor models provide insight into a fund’s risk/return profile (including the risks taken by the
fund’s managers), allow for accurate risk attribution, help with accurately forecasting future
risks, and identify the contribution the manager is making to the fund’s overall return.
3. A factor model should be intuitive, should be estimated in a reasonable amount of time, should
be parsimonious, should reflect commonalities across funds, and should help managers with
decision making.
4. A general linear factor model expresses returns as a function of a single factor.
5. The Capital Asset Pricing Model (CAPM), the most famous single-factor model, expresses
return as a function of the market risk of the asset.
6. Single-factor models are too limited to capture the complexity of hedge fund returns. Consider
the various hedge fund styles, investment opportunities, markets, long and short positions and
degrees of leverage as examples of this complexity.
7. In a general linear multi-factor model, return is related to more than one underlying risk factor.
In general form the model is:

8. Principal component analysis is a statistical technique that allows the researcher to distill a
vast amount of data into a few common factors without losing much of the information in the
original data (thus accomplishing dimension reduction). The factors are implied by the data
and do not have a direct economic interpretation.
9. Common factor analysis is another statistical tool used to accomplish dimension reduction. A
key difference is that the factors in factor analysis are observable and explicitly identified by
the researcher.
10. Fama and French developed a three-factor model that includes two additional risk factors
relative to the CAPM. Their model indicates that both market capitalization (SMB) and book-
to-market ratios (HML) help explain returns.
11. Jagadeesh and Titman find evidence of a momentum effect in stock market returns. That is,
stocks that have performed well continue to perform well and stocks that have performed
poorly continue to perform poorly (WML).
12. The Fama and French model redefined to include a momentum factor is:

13. Other factors that may influence hedge fund returns, as suggested by various researchers,
include trading styles, interest rates, equity related factors, growth, the age and/or size of the
fund, and so on.
14. An analyst or investor can use multiple-factor models to help explain hedge fund returns and
risks, help create performance benchmarks and index trackers, help develop trading
strategies to increase sensitivity to some risk factors and decrease it to others, and to help
assess whether a manager generated positive alpha.
15. Traditional asset models assume that volatility is the appropriate risk measure for an asset (or
portfolio of assets) and that risk exposures are constant over time.
16. Skewness is a measure of the asymmetry of the distribution. It is the third moment of the
return distribution. Investors prefer positive skew and want to avoid negative skew. Co-
skewness considers an asset’s contribution to the skewness of the portfolio or fund, and is
more relevant than the skewness of the asset alone.
17. Kurtosis is the fourth moment of the distribution and measures the “peakedness” of the
distribution. Co-kurtosis is concerned with the kurtosis contribution of an asset to the portfolio
or fund.
18. Rubinstein developed a model relating return to the higher moments of the distribution such as
skewness and kurtosis.
19. Kraus and Litzenberger developed a three-moment CAPM (i.e. a quadratic CAPM) that allows
an analyst to test for skewness preferences. The model is:

20. The cubic form of the model includes a factor that is related to the fourth moment (kurtosis).
The model is:

21. In 1966 Treynor and Mazuy proposed a quadratic asset pricing model that considers market
timing as a systematic risk factor. The model is identical to the quadratic model proposed by
Kraus and Litzenberger.
22. Conditional asset pricing models such as the CAPM assume risk is constant through time.
Unconditional models do not make this assumption and thus may be more appropriate for
modeling hedge fund returns.
23. Hedge funds are like options in terms of their fee structure, in terms of trading strategies that
target classes of investors and in terms of the asymmetric, non-linear payoff profiles.
24. Henriksson and Merton (1981) developed a model that views a hedge fund’s return as the
sum of the return on the market and on a put option on the market. The model is:
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25. Fung and Hsieh identify three components to hedge fund returns: location factors, trading
strategy factors, and a leverage factor.
26. Fung and Hsieh provide a framework for looking at hedge fund strategies in terms of option
27. Agarwal and Naik propose several buy-and-hold risk factors that influence hedge fund returns.
They include equity, bond, style and default spreads.
28. Agarwal and Naik find that their model has better explanatory power (higher R ) than the Fung
and Hsieh model.
29. Amin and Kat show that investors can generate the same payoff distribution as a hedge fund
using dynamic trading strategies.
30. An investor can achieve superior returns by either increasing beta (taking on more risk) or
generating alpha (being a superior market timer, asset selector, etc.).
31. If the asset pricing model is specified incorrectly, it is possible to make the erroneous
conclusion that hedge fund managers are generating positive alpha when in reality they are
merely increasing beta exposure.
9. Styles, Clusters, and Classifications

1. Hedge funds can use self-classification, but because of the lack of stringent regulation, it is not
unusual for a hedge fund manager to deviate from the goal of the fund as implied by its name
and even the goal as stated in the prospectus. Hence, quantitative methods are needed to
classify hedge funds.
2. Fundamental style analysis, also called holding-based style analysis, classifies hedge funds
by the type of assets held. Characteristics like the assets’ markets and geographical location
classify the fund.
3. The characteristic-based approach is similar to the fundamental approach except it uses
measures like the assets’ book-to-market, momentum, etc.
4. Return-based style analysis only requires the historical returns of the funds. Hence, it is an
easier and cheaper substitute for holdings-based (fundamental style) analysis. However, it can
be much less accurate.
5. Multifactor analysis involves the estimation of the following model:
where the factors are usually style indices and the betas are the style sensitivities.
6. In estimating the multifactor model, the style indices should have the following three
properties: mutually exclusive, exhaustive, and sufficiently different in their behavior from each
7. Analysts usually constrain multifactor analysis with either or both of the following: (1) the sum
of the betas equals 100%, (2) some or all of the betas are greater than or equal to zero.
8. Strong style analysis is the name used when both constraints are imposed: the betas cannot
be negative, and the betas sum to 100%.
9. The familiar R-square, or percent of variation explained, measure applies to constrained
optimization estimation techniques used in multifactor analysis. It tells how well the model fits
the data.

10. Style analysis radar charts can give a succinct, visual representation of the style exposures of
a fund. Such a chart has rays extending from a point of origin, and each ray indicates a
different style index. A set of lines crossing the rays indicate the level of exposure to each
11. The Herfindahl-Hirschman concentration index, or HHI, gives a quantitative measure of the
diversification of the fund. It is the sum of the squared betas from a multifactor analysis divided
by the square of the sum of the betas:
%& % '
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12. Rolling window analysis can indicate how a fund’s investment style changed over time. It
performs the multifactor analysis on an initial sub-period and then performs it over and over on
a new sub-period moved one period forward from the previous period. The pattern of the
many sets of betas reveals whether the strategies of the fund might have drifted over time.
13. Rolling benchmarks allow an analyst to track the manager’s style drifts, while static analysis
does not.
14. The Lobesco and DiBartolomeo style weight error is essentially the standard error of a style
exposure: % . It is represented by ()* , and it can be used to compose standard confidence
intervals like # % + ()* , % + ()* ' for a 95% confidence interval.
15. Style analysis can be misused due to the use of subjective inputs and because an analyst
may find it easy to rely too much on the quantitative results and neglect important qualitative
16. Making adjustments to measure current exposure is important because a factor analysis of
past data may not accurately reflect current exposure.
17. The Kalman filter uses multifactor analysis to model the changes of sensitivities over time and
can give an indication of current exposure and even predict future exposure.
18. The Swinkels and van der Sluis’ application of the Kalman filter models the changes of
sensitivities (e.g., the betas) as a random walk.
19. The Kalman smoother is a descriptive technique that uses the entire data set to describe the
style sensitivities at any point. It is superior to rolling windows, which only use past data to
show changes in style sensitivities at any point in time.
20. In hedge fund analysis, cluster analysis attempts to group funds by certain characteristics.
21. The four common steps of cluster analysis are choosing (1) the characteristics, (2) the
measure of distance, (3) the particular algorithm, and (4) the interpretation of the results.
22. In cluster analysis, an analyst may wish to standardize the data in some way (e.g., removing
the effect of leverage from the funds under study).
23. Cluster analysis uses distance functions to determine the degree of similarity of objects.
24. Distance functions must have the following four properties:
• Identity: D(m,m) = 0
• Non-negativity: D(m,n) = 0
• Symmetry: D(m,n) = D(n,m)
• Triangle inequality: D(m,n) < D(m,q) + D(q,n)
25. The Minkowski class of distances refers to all functions that take the following shape:
4 63
- ., /01 2, , 1 5

26. There are two often-used values for s in the Minkowski class: s = 1 and s = 2. An analyst
would rarely assign s > 2, because this would give outliers too high of a weight.
27. When s = 1 in the Minkowski class, it is simply the sum of absolute deviations called the
Manhattan distance or city-block distance.
28. When S = 2 in the Minkowski class, the result is the standard Euclidean distance.
29. A higher correlation between two funds means they are more similar and should have a
smaller distance. One transformation to create a distance function using correlation is:
- .,

30. Binary distance is a simplistic measure in which an exact match gives a value of one, and the
value zero indicates no match exists between any pair of cases.
31. Euclidean distance can be biased if the characteristics have widely different variances.
32. The Mahalanobis distance corrects for the biases in Euclidean distance associated with
correlated characteristics and different variances.
33. The hierarchical clustering approach is a step-wise procedure that can be either top down or
bottom up.
34. Johnson’s hierarchical clustering algorithm begins by having each fund in its own group. It
then looks for the distance between two clusters that is the shortest of all distances between
any two clusters. The two clusters that are the closest become one cluster. The process then
repeats with the new set of clusters.
35. Johnson’s hierarchical clustering algorithm can use one of many distance measures. Once the
clustering has started, the distance may be either the distance between the closes two
members of each pair of clusters, for example, or the most distant two members.
36. Ward’s method uses an analysis of variance approach to evaluate each step in the clustering
process. It forms the next cluster at each step that minimizes the increase in the total of the
sums of squares within groups.
37. Fuzzy clustering gives each object a set of probability values – one probability for each
cluster. Each of the probability values essentially tells the likelihood of that object belonging to
a given cluster.
38. Hard clustering is the term used for traditional approaches that set up partitions and give only
one cluster assignment to each object.
39. The Rand index is a measure of the difference of the clustering results that different
algorithms produce.
40. When comparing two methods, the Rand index is essentially the percent of pairs that are in
the same cluster in both clustering algorithms. Rand index = 1 means identical groupings.
Rand index > 0.7 means the groupings are stable across methods.
41. Martin, Brown and Goetzmann, and Bares et al. are three studies of clustering analysis as
applied to hedge funds:
• Martin found that some classifications were more stable over time than others, and
that individual funds in a given cluster can react quite differently to changes in
economic conditions.
• Brown and Goetzmann found a great deal of heterogeneity in hedge fund behavior.
Style classifications explained 20% of the differences, and the style of fund
management determined the persistence of fund returns from year to year.
• Bares et al. performed cluster analysis based on managers. The managers’ records
had been gathered from the FRM database where they had already been classified.
Bares et al. found that the clustering analysis gave results similar to the classifications
the funds had in the FRM database. Other analysis supported the usefulness of
cluster analysis in classifying hedge funds.
10. Benefits and Risks Revisited

1. Three reasons for superior returns of the hedge fund industry are:
• Fewer investment restrictions
• Less constrained work environment
• Superior compensation
2. Hedge fund index returns have been higher than most major stock and bond market indices.
Standard deviations and maximum drawdowns have also been less than those of major equity
3. Correlations among traditional global market indices increased recently. Correlations between
stock and bond markets, at times, also have been high. Therefore, hedge funds have become
an increasingly attractive diversification alternative.
4. Rates of return and standard deviations are much better for hedge fund indices versus the
S&P 500 during bear markets. Therefore, hedge funds (as a group) have delivered on their
intended objective to provide important downside risk protection.
5. Risk, return, and correlations have varied widely across the different hedge fund strategies. As
expected, market neutral and arbitrage strategies exhibited the lowest risk and strategies with
directional bias exhibited the highest risk. Short bias strategies exhibited a large negative
correlation with the S&P 500, while net long, distressed risk, and emerging market strategies
exhibited the largest positive correlations with the S&P 500.
6. Hedge fund strategies are generally positioned into four different styles or categories:
• Low risk – low return: relative value strategies, such as market-neutral and arbitrage
• Low risk – high return: distressed risk strategies
• High risk – low return: risk diversifying strategies, such as managed futures and
emerging market strategies
• High risk – high returns: global macro and long/short strategies
7. A long-term analysis of hedge fund performance is difficult because very few funds have
existed for an extended time period. Since current analysis has been confined to a period in
which the broad market has risen, strategies with a long bias have enjoyed a performance
8. Hedge fund index performances are difficult to track because they are computed gross of
transaction costs and do not consider the minimum investment. Moreover, hedge funds are
under no mandatory reporting requirement, so underperforming managers may elect to not
report their performance. This introduces an upward bias. Therefore, hedge fund index
performance may not be representative of the entire hedge fund industry.
9. Some hedge fund strategies rely on the exploitation of a limited set of opportunities.
Therefore, constrained opportunity strategies have encountered a particularly difficult time as
more capital has poured into these funds, and as a result have not sustained their earlier
11. Strategic Asset Allocation

1. Strategic asset allocation is the process of choosing portfolio weights for asset classes as
opposed to choosing the individual assets within each class. The choice of weights should
be for a long-term horizon and should be congruous with the investor’s return objective
and risk tolerance.
2. The St. Petersburg paradox is a game with an infinite expected value payoff. However,
people will only pay a finite amount to play because of risk aversion. It serves as an
example to prove people are risk averse.
3. Utility functions can describe an investor’s preference for return and aversion to risk. The
quadratic utility function is a popular function that includes an easily interpreted
expression for risk aversion:

4. The steps in portfolio optimization: select the appropriate asset classes, make forecasts,
recognize constraints such as non-negativity of certain asset class weights, optimize
based on a criteria such as minimizing risk for each given level of return, review the
results, and perform sensitivity analysis.
5. There are problems with saying that hedge funds are an “asset class”. There are many
different types of hedge funds. They often include risk exposures found in traditional
assets, such as stocks and bonds.
6. When including hedge funds in a portfolio, a manager should recognize how they might
serve as substitutes for traditional asset classes. This is because they often have risk
exposures and return characteristics similar to traditional assets (e.g., a long/short equity
fund that is net long will have returns that are correlated with the returns of an equity
7. Since traditional methods of analysis do not seem to apply to hedge funds, managers
often choose informal approaches such as arbitrarily picking a small allocation (e.g., 5%,
for hedge funds). Another informal approach is to simply allocate zero capital to hedge
funds without performing any analysis.
8. Mean-variance optimizer solutions have problems when applied to hedge funds because
they do not consider skewness and kurtosis, which hedge fund returns generally exhibit.
9. The Taylor series expansion illustrates the role higher moments about the mean (such as
skewness and kurtosis) play in an investor’s utility function. The formula is:

where n indicates the moment about the mean.

10. Mean-variance optimization works fairly well when a portfolio only includes traditional
asset classes because the returns for these classes are usually close to being normal,
which means that moments higher than the second moment are (close to) zero. In
contrast, the higher moments for hedge funds can be quite large, and mean-variance
optimization may not give the most efficient asset class weights when hedge funds are
included in the portfolio.
11. The differences between static buy-and-hold portfolios and dynamic portfolios is another
reason that mean-variance optimization may not be appropriate for choosing hedge fund
weights. This is because hedge funds are usually actively managed and their
characteristics can change quite dramatically over the investment horizon. Thus, the initial
strategic asset allocation may become inappropriate soon after its implementation.
12. Because of the way hedge fund returns are reported (i.e., based on estimates rather than
actual transactions), the time series of the returns may be artificially smooth. This can lead
to downward bias in the calculated values of return variance.
13. Geltner proposed the following transformation, which uses the autocorrelation coefficient
of the observed returns to unsmooth the data:
$%&! '!( ! # ) $%&! '!( ! #*+
! ! #
14. Methods for eliminating estimation risk include (1) subjectively adjusting forecast as new
information arrives, (2) the statistical shrinkage approach, (3) combining market
equilibrium values with investor’ expected returns, and (4) bootstrapping. There is also the
Michaud resampled efficiency algorithm to limit the impact of estimation risk.
15. Non-standard efficient frontiers use risk measures other than variance (e.g., the semi-
variance, VaR, and shortfall risk). Evidence of the benefits of this approach is not strong.
There are potential problems with the approach including estimation risk and difficulties in
relating the risk measures of individual positions to the overall portfolio.
16. Portable alpha refers to an investment strategy designed to transfer the excess return
(alpha) of one portfolio to another portfolio.
17. The following is an expression for total return:
$ ,- ! ,-./, 0,&/ ! %! 0/1, 2 ! 0,&/ !
This helps indicate how to separate alpha from a position that is not market neutral. The
manager can neutralize the second expression with, for example, a position in derivatives.
The new portfolio has only pure alpha and can serve as a means for adding alpha to
another portfolio.
18. The portable alpha mindset is one where an investor can benefit from the skills of
managers of funds that have risk exposures the investor may not want. The investor can
eliminate the risk and transport the alpha to his or her portfolio.
19. Hedge funds usually have both alternative risk exposures and exposures to the risks of
traditional assets. Pinpointing the specific types and levels of risk of hedge funds and
other assets under consideration will lead to the construction of more optimal portfolios.
20. Risk budgeting is the selection of asset classes on the basis of their expected
contributions to overall return and risk with the goal of achieving a level of return with only
the desired risk exposures and aggregate level of risk.
12. Risk Measurement and Management

1. The crucial risk management activities are to understand the risk exposures, measure the
exposure to each risk, measure the aggregate exposure of each fund, measure the risk of the
hedge fund portfolio, and choose the risk exposures.
2. Value at risk (VaR) is generally interpreted as the worst possible loss under normal conditions
over a specified period.
3. The main assumptions of parametric VaR are that the risk factors are normally distributed and
that the fund’s prices and returns have a linear relationship with the risk factors.
4. Historical VaR assumes that the historical patterns indicate the distribution of current and
future outcomes such that losses in the future will occur with the same frequency and
magnitude as they did in the past.
5. Monte Carlo VaR simulates values for risk factors and uses them to simulate returns for a
hedge fund or portfolio of funds.
6. Parametric VaR can greatly underestimate VaR if the normality of returns and other
parametric VaR assumptions are not true. Modified VaR attempts to incorporate adjustments
when the distribution is near but not exactly normal.
7. Modified VaR incorporates skewness and kurtosis into parametric VaR.
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8. Modified VaR is not reliable if the measures of skewness and kurtosis are too large.
9. Extreme events are those that occur in the tail of the assumed distribution. Two approaches to
model them are (1) gather a sample, divide the sample into blocks, measure the minimum
return in each of these blocks; (2) model the behavior of observations in the tail of a
distribution separately from those near the center.
10. A multi-factor style analysis allows for the calculation of value at market risk (VaMR), which is
the maximum loss from adverse changes in market factors that can occur under normal
conditions. Estimating value at market risk uses the betas from a multi-factor style analysis
and assumed values for the factors that have been pushed to a disadvantageous level.
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11. Value at specific risk is essentially the square root of the unexplained variance of the return
from a multi-factor analysis times the corresponding z-value for the level of confidence.
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12. The expression for total VaR obtained using style analysis is:
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13. The liquidity spread is the loss incurred from withdrawing funds today as opposed to waiting N
periods, and it is the difference in the corresponding net asset values.
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14. Laporte’s model or L-VaR breaks down VaR into the following parts: systematic market VaR,
specific market VaR, systematic liquidity VaR, specific liquidity VaR, and correlation effects
between liquidity and market risk. This decomposition allows for a more detailed analysis of
the effect of liquidity constraints.
15. The main limitation of VaR is that it gives a value of potential loss only under normal
conditions, and it does not indicate the losses that can occur when extreme events occur.
Other limitations are that it is a single measure that should not preclude the use of qualitative
16. Stress tests compute the losses to a fund when extreme market moves occur. The test may
use extreme historical values, estimates of extreme values using statistics, or worse case
losses from a Monte Carlo simulation.
17. Monte Carlo simulations can provide thousands of hypothetical returns for both a single fund
and a portfolio of funds. One general approach is to fit a statistical distribution to the historical
returns of a fund and generate values using that distribution. When applied to generating
portfolio returns, the simulations will need to include the correlations of the funds’ returns.
18. Marginal VaR (MVaR) is a measure of how a portfolio VaR changes from a small change in
the position of a fund in the portfolio.
19. Incremental VaR (IVaR) is an estimate of the amount of risk a proposed position will add to
the total VaR of an existing portfolio. It is the proposed weight for that fund times the marginal
VaR evaluated when wi is zero.
20. Component VaR (CVaR) is the contribution of a particular fund to a portfolio of funds. It will
generally be less than the VaR of the fund by itself because of the diversification of some of
the fund’s risk at the portfolio level.
21. Managing a portfolio of funds might begin with decomposing the risk into the CVaR of each
position. This can indicate if any one position is a hot spot. In determining the correct course
of action, the manager can use marginal VaR to estimate the effect of changes in existing
positions, or the manager can use incremental VaR to estimate the effect of adding a new
fund to the portfolio.
22. A manager should remember that VaR values are estimates. Furthermore, each fund will have
special features that will affect its liquidity.
23. Studies have shown significant benefits even from naïve diversification, which is taking equal
positions in different funds. Smart diversification, which uses the characteristics of the funds to
adjust the weights, can further increase the benefits. Most of the benefits can be achieved with
five to ten funds.
24. Di-worse-ification is the result of having too many positions. Adding a position without
reducing other positions will generally increase the portfolio’s VaR in nominal terms. Also,
there is a decrease in the marginal benefits of diversification as the manager adds new
positions. Transaction costs can exceed potential benefits if there are too many positions.
Standards of Professional Conduct

I. Professionalism

A. Knowledge of the Law

Members and candidates must understand and comply with all applicable laws, rules,
and regulations of any government, regulatory organization, licensing agency, or
professional association governing their professional activities. In the event of conflict,
members and candidates must comply with the more strict law, rule or regulation.
Members and candidates must not knowingly participate or assist in any violations of
laws, rules, or regulations and must disassociate themselves from any such violation.

B. Independence and Objectivity

Members and candidates must use reasonable care and judgment to achieve and
maintain independence and objectivity in their professional activities. Members and
candidates must not offer, solicit, or accept any gift, benefit, compensation, or
consideration that reasonably could be expected to compromise their own or another’s
independence and objectivity.

C. Misrepresentation

Members and candidates must not knowingly make any misrepresentations relating to
investment analysis, recommendations, actions, or other professional activities.

D. Misconduct

Members and candidates must not engage in any professional conduct involving
dishonesty, fraud, or deceit or commit any act that reflects adversely on their
professional reputation, integrity, or competence.

II. Integrity of Capital Markets

A. Material Nonpublic Information

Members and candidates who possess material nonpublic information that could
affect the value of an investment must not act or cause others to act on the

B. Market Manipulation

Members and candidates must not engage in practices that distort prices or artificially
inflate trading volume with the intent to mislead market participants.
III. Duties to clients

A. Loyalty, Prudence, and Care

Members and candidates have a duty of loyalty to their clients and must act with
reasonable care and exercise prudent judgment. Members and candidates must act
for the benefit of their clients and place their clients’ interests before their employer’s
or their own interests. In relationship with clients, members and candidates must
determine applicable fiduciary duty and must comply with such duty to persons and
interests to whom it is owed.

B. Fair Dealing

Members and candidates must deal fairly and objectively with all clients when
providing investment analysis, making investment recommendations, taking
investment action, or engaging in other professional activities.

C. Suitability

1. When members and candidates are in an advisory relationship with a client, they

a. Make a reasonable inquiry into the client’s or prospective client’s investment

experience, risk and return objectives, and financial constraints prior to
making any investment recommendation or taking investment action and must
reassess and update this information regularly.
b. Determine that an investment is suitable to the client’s financial situation and
consistent with the client’s written objectives, mandates, and constraints
before making an investment recommendation or taking investment action.
c. Judge the suitability of investments in the context of the client’s total portfolio.

2. When members and candidates are responsible for managing a portfolio to a

specific mandate, strategy, or style, they must make only investment
recommendations or take investment actions that are consistent with the stated
objectives and constraints of the portfolio.

D. Performance Presentation

When communicating investment performance information, members or candidates

must make reasonable efforts to ensure it is fair, accurate, and complete.

E. Preservation of Confidentiality

Members and candidates must keep information about current, former, and
prospective clients confidential unless any of the following occur.

1. The information concerns illegal activities on the part of the client or prospective

2. Disclosure is required by law.

3. The client or prospective client permits disclosure of the information.

IV. Duties to Employers

A. Loyalty

In matters related to their employment, members and candidates must act for the
benefit of their employer and not deprive their employer of the advantage of their skills
and abilities, divulge confidential information, or otherwise cause harm to their

B. Additional Compensation Arrangements

Members and candidates must not accept gifts, benefits, compensation, or

consideration that competes with, or might reasonably be expected to create a conflict
of interest with, their employer’s interest unless they obtain written consent from all
parties involved.

C. Responsibilities of Supervisors

Members and candidates must make reasonable efforts to detect and prevent
violations of applicable laws, rules, regulations, and the Standards by anyone subject
to their supervision or authority.

V. Investment Analysis, Recommendations, and Action

A. Diligence and Reasonable Basis

Members and candidates must:

1. Exercise diligence, independence, and thoroughness in analyzing investments,

making investment recommendations, and taking investment actions.

2. Have a reasonable and adequate basis, supported by appropriate research and

investigation, for any investment analysis, recommendation, or action.

B. Communication With Clients and Prospective Clients

Members and candidates must;

1. Disclose to clients and prospective clients the basic format and general principles
of the investment processes used to analyze investments, select securities, and
construct portfolios, and must promptly disclose any changes that might materially
affect those processes.

2. Use reasonable judgment in identifying which factors are important to their

investment analyses, recommendations, or actions, and include those factors in
communications with clients and prospective clients.

3. Distinguish between fact and opinion in the presentation of investment analysis

and recommendations.
C. Record Retention

Members and candidates must develop and maintain appropriate records to support
their investment analysis, recommendations, actions, and other investment-related
communications with clients and prospective clients.

VI. Conflicts of Interest

A. Disclosure of Conflicts

Members and candidates must make full and fair disclosure of all matters that could
reasonably be expected to impair their independence and objectivity or interfere with
respective duties to their clients, prospective clients, and employer. Members and
candidates must ensure that such disclosures are prominent, delivered in plain
language, and communicate the relevant information effectively.

B. Priority of Transactions

Investment transactions for clients and employers must have priority over investment
transactions in which a member or candidate is the beneficial owner.

C. Referral Fees

Members and candidates must disclose to their employer, clients, and prospective
clients, as appropriate, any compensation, consideration, or benefit received by, or
paid to, others for the recommendation of products or services.
16. Introduction to Real Estate Valuation

1. The future value of a lump sum is equal to the present value compounded by an interest rate
for one or more periods.
• Future value can be calculated for any number of periods and interest rates using the
following formula:
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• Future value can be calculated for any number of periods using the same interest rate
with the following formula:
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2. The present value of a lump sum is equal to the future value discounted by an interest rate for
one or more periods.
• Present value can be calculated for any number of periods and interest rates using
the following formula:
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• Present value can be calculated for any number of periods using the same interest
rate with the following formula:
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3. The discounted cash flow approach to valuing real estate property requires estimating all
future cash flows for the property, which are then discounted to their corresponding present
values and summed.
• If it is appropriate to use a different discount rate for each period, the value of a
property can be calculated using the following formula:
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• If it is appropriate to use the same discount rate for each period, the value of a
property can be calculated using the following formula:

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4. Generally it is not feasible to forecast all future cash flows. Thus, the use of a reversion value
at the end of the forecast period is necessary to represent cash flows beyond the forecast
period. The reversion value is added to the final forecast year’s cash flow and requires that net
operating income is stabilized and will grow at a constant rate. Reversion value can be
calculated as follows:
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5. Net present value (NPV) is the present value of an asset minus its initial cost and represents
the increase in firm value by investing in the asset. NPV can be used to make investment
decisions using the following rules:
• If NPV > 0, the investment is acceptable.
• If NPV < 0, the investment should be rejected.
• If NPV = 0, the investment is acceptable but will add no equity value.
6. Calculating the NPV of an investment involves discounting the expected cash flows, summing
the discounted cash flows, and subtracting the initial cost to undertake the investment.
7. An investment’s internal rate of return (IRR) is the discount rate that results in an NPV equal to
zero. IRR can be used to make investment decisions using he following rules:
• If appropriate discount rate > IRR, reject the investment (negative NPV).
• If appropriate discount rate < IRR, accept the investment (positive NPV).
• If appropriate discount rate = IRR, accept or reject the investment (NPV = 0)
8. IRR can be calculated by using a calculator (recommended for the exam) or by using a three-
step process.
9. IRR has several shortcomings that make it difficult to simply select the investment with the
highest IRR. These shortcomings include a failure t consider the risk of the investment, timing
of cash flows, size of cash flows, length of investment period, type of cash flows, suitability of
different discount rates, and financing risk.
10. The amortization of a real estate loan is a schedule of principal repayments.
• A zero-amortization loan repays no principal until the maturity of the loan.
• A fully amortized loan has a maturity and an amortization period that are equal. The
periodic payment is constant, but the proportion allocated to principal (interest)
increases (decreases) with each payment.
• The amortization period may be longer than the maturity of the loan.
11. The annual payment on a real estate loan may be calculated using annuity factors, a loan
constant table, or a calculator.
• Annuity factor method:
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• Loan constant method:
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12. As the amortization period of a loan decreases, principal payments increase, interest
payments decrease, and the tax shield from interest decreases. The net effect is a decrease
in after-tax cash flows. The reverse is true as well.
13. In a negative amortization loan, interest accrues over regular intervals during the accrual
period and is then added to the principal balance at the end of the accrual period. During the
accrual period, additional principal may also be borrowed.
14. Increased vacancy will cause a decrease in net base rental revenue, a decrease in ancillary
revenue, a decrease in overages (if retail space is vacant), and a decrease in reimbursed
15. Total rental income is equal to gross potential income minus income lost to vacancy plus any
percentage rents (also called overages).
• Gross potential rent can be calculated using lease-by-lease analysis or using a
simplified formula:
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• Revenue lost to vacancy can be calculated as a percentage of gross potential rental
revenue or as expected vacant square footage multiplied by average base rent per
square foot.
• Percentage rents are a predetermined percentage of a retail lessee’s sales over a
certain level called the breakpoint.
16. Operating expenses can be calculated as the sum of the reimbursable expenses (common are
maintenance costs, property taxes, etc.) and non-reimbursable expenses (insurance, utilities,
management fees, etc.) necessary for day-to-day operations.
17. Net operating income is equal to total operating income minus total operating expenses.
18. Tenant improvements (TIs) are modifications or upgrades made to rental space to suit the
tenant’s operational requirements. A portion of the cost of TIs may be incurred by the property
19. Capital expenditures (cap ex) are large capital outlays to update and repair the property in
order to remain competitive. The cost of cap ex is borne by the property owner.
20. Depreciation is calculated using the following formula:
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• Depreciable life is determined by the category the asset falls into: 27.5 years for
residential structures, 39 years for other structures, and three to seven years for
• TIs are depreciated by half in the first year, and the other half is amortized for the
lease term.
• Cap ex is treated as an improvement (three to seven years).
21. Leverage decreases the cash flow available to equity holders and increases the risk of the
cash flows. There is a tax savings resulting from interest an loan point amortization, but the
requisite debt service results in a net decrease in cash flow to equity.
22. Company analysis begins with a roll up of the individual properties held by a company but
then extends to include company-level items not reflected in the properties such as corporate
general and administrative expenses, corporate capital expenditures and depreciation,
corporate debt, and corporate income not derived from real estate assets.
23. The value of a real estate company will be greater than the value of its properties if competent
management successfully undertakes value-added initiatives and will be less than the value of
its properties if incompetent management undertakes value-destroying initiatives.
24. The value of a real estate company can be calculated sing three approaches:
• The discounted cash flow approach uses the following formula to determine company
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• Cash flows are defined as follows:
• The cap rate approach assumes cash flows are already stabilized and uses the
following formula to calculate company value:
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• The net asset value approach assumes that management adds no value and sums
the capitalized values of the income from properties and management or fee-related
services and the values of the development business, raw land, and the cash position.
Total debt and liabilities are subtracted to determine the net asset (i.e., equity) value.
Property income is capitalized using the cap rate approach with a market observed
discount rate. Income from management or fee-related services is capitalized using
market observed multiples.
25. Net asset value calculations are highly sensitive to the cap rate since it is used to value the
largest asset owned by the company, its property portfolio. Small cap rate changes lead to
large property value and net asset value changes.
17. Debt and Mortgages

1. Several ratios are used to measure the ability of the borrower to meet debt obligations (i.e., to
assess the risk of the loan):
• The loan-to-value ratio (LTV) is the remaining balance of the loan divided by the
(market) value of the property.
• The interest coverage ratio, calculated as the property’s net operating income (NOI)
divided by the amount of annual interest payable.
• The debt service coverage ratio (DSCR) is calculated as the property’s NOI divided by
the total loan payment, including interest and principal.
• The fixed charges ratio is yet another way of measuring the ability of the owners (i.e.,
the property) to meet their financial obligations.
2. A positive loan covenant is something the borrower must do, such as maintain the property. A
negative loan covenant is something the borrower cannot do, such as pay dividends before
interest is paid.
3. Other real estate loan terms include:
• The loan’s maturity and rate of interest.
• Whether the loan is fully or partially amortized (balloon payment) or is interest-only.
• The payment dates.
• Any primary and secondary assets the lender can claim in the event of default
• The creditor’s right to sweep cash flows.
• When and how the owner can make draws on a construction loan.
• The proportion of leases that must be signed (rental properties) before the loan is
4. The primary benefits of refinancing include lower interest rates and the ability to withdraw
funds from the project. Costs of refinancing include loan origination fees (points) and
prepayment penalties. Opportunity costs include time spent in making the refinancing
decision. Another consideration is the new loan covenants.
5. There are at least four situations under which refinancing a loan is worthwhile:
• Interest rates have fallen enough to warrant paying the prepayment penalty (if
replicable) and other costs.
• Owners are able to withdraw capital tax-free.
• Creditworthiness has increased dramatically, and you are now able to borrow at
significantly lower rates.
• Originally lender willing to waive the prepayment penalty to avoid losing you to a
6. To make the process more efficient, every participant in the CMBS process specializes in the
area in which they have the greatest skills and experience. The CMBS pool originator
assembles the loans and markets the pool. The CMBS are issued by an SPC. The master
servicer services the loans, and the special servicer handles loans that are in default or
7. A pool of fixed-rate loans with different characteristics is known as a fixed-rate fusion pool.
Conduit loans are smaller loans that are originated with the intent of placing them in a CMBS
pool. In a net credit lease (a.k.a. closed-end lease), the tenant (the lessee) pays all expenses
related to operating the asset or property (i.e., the expenses normally associated with
ownership). The risk inherent in CMBS is determined by the creditworthiness of the borrower.
8. The loans in a CMBS pool are separated into classes known as tranches. Some tranches may
be interest-only tranches, while others can have claims on the repayment of principal. The
tranches can pay fixed or floating rates.
9. Rating agencies assess the risk-associated with each tranche and give each a rating. Rating
agencies play an integral role in the CMBS process in providing risk assessment mechanism
for investors while maximizing the price received by the loan originators.
10. Due to the resulting specialized cash flows, investors might be willing to pay a premium for a
tranche’s cash flows.
11. The risk of a CMBS pool or a single tranche can be assessed by looking at the loan-to-value
ratio (LTV), the interest coverage ratio, the debt service coverage ratio (DSCR) (i.e., the
percent of loans in default), or the composition of the tranches.
18. Real Estate Returns

1. Capital gains taxes are paid on the increase in the value of the property. Recaptured
depreciation is the amount of depreciation that was taken since the property was purchased
that is taxed when the property is sold.
2. Real estate exit strategies include selling, refinancing, like-kind exchange, trading for an
interest in a public company, and going public.
3. Real estate private equity funds are typically structured as limited partnerships, with the fund
sponsor serving as the general partner.
4. Pref is the preferred IRR on invested funds. The money refers to the cash invested in the fund,
so money contributed by the fund sponsor is considered part of the money. Cash waterfall is
the name given to the cash flows (profits) generated by the private equity fund and how they
are divided among the money. Profits paid to the sponsor are referred to as the sponsor’s
promote or carried interest.
5. The most common cash waterfall divides all profits 80/20 as long as the pref is earned. In an
alternative method the 80/20 split only applies to profits in excess of the pref.
6. Real estate cycles are driven by supply and demand imbalances. Unlike most consumer
products or financial assets, the real estate market can take years to return to supply and
demand equilibrium.
7. The real estate market can take years to return too supply and demand equilibrium because it
can take years to plan, raise funds, and build an office building or other commercial real estate
8. The rate at which over-supply is corrected (i.e., the rate at which vacant properties are
utilized) is referred to as the absorption rate, which is influenced by the information lag (the
time it takes to collect and organize data) and regulatory approvals (e.g., rezoning).
9. The Wharton Real Estate Index shows the supply of real estate capital relative to demand. An
index value of 100 is used to approximate equilibrium conditions. A value over (less than) 100
indicates excess (insufficient) supply compared to demand.
10. Although there isn’t technically a “national” real estate market, forecasting real estate trends
on a national level is less difficult than on a local or regional basis.
11. The National Council of Real Estate Investment Fiduciaries (NCREIF) Index shows quarterly
(unleveraged) real estate returns based on annual appraisals of core properties. Returns,
typically in the high single digits, are less volatile than the NAREIT Index returns.
12. The National Association of Real Estate Investment Trusts (NAREIT) Index uses transaction
data to generate returns, usually in the 10% to 12% range, for publicly traded REITs, which
invest in high quality properties. Since REITs employ leverage in their purchases, index
returns reflect a moderate (~50%) use of leverage.
13. Using either the NAREIT or NCREIF Index as a stand-alone benchmark for private equity
funds is inappropriate. However, these indices may be combined with a fixed rate to create a
suitable benchmark.
14. Private equity funds should earn approximately 7% above the NAREIT and 10% above the
19. Introduction to Hedge Funds

1. Compared to mutual funds, hedge funds:

• Are private investment vehicles for sophisticated investors.
• Have concentrated portfolios with a fewer number of holdings.
• Use derivatives more frequently
• May take long or short positions in securities.
• Use leverage, sometimes in large amounts
• Invest in private placement securities.
2. There are four primary categories of hedge funds:
• Market directional funds have some degree of market risk exposure that causes the
fund o be impacted by market conditions.
• Corporate restructuring funds attempt to profit from corporate events such as
bankruptcies and mergers.
• Convergence trading strategies take offsetting long and short positions in similar
securities to profit from a narrowing of the spread between the two securities.
• Opportunistic strategies try to take advantage of whatever opportunities may be
present in the marketplace.
3. Equity long/short strategies combine long stock positions with short positions to construct a
portfolio with reduced exposure to market risk.
• The ability to go both long and short opens up the opportunity to gain regardless of
market direction.
• Fundamental equity long/short strategies analyze the business prospects of
companies within an industry from a bottom-up perspective.
• Quantitative equity long/short strategies use complex multifactor modules to select
• Weighted average beta = (w1 × ß1) + (w2 × ß2) + … + (wn × ßn)
4. Market timing strategies rely on the analysis of macro economic factors and attempt to be fully
invested in the market (long) when the market is rising and stay in cash when the market is
• Market timers rely on top-down analysis, rather than the bottom-up approach of equity
long/short managers.
• Market timers eliminate unsystematic risk exposure and use stock index futures to
determine when to add systematic risk exposure. Equity long/short funds exploit
unsystematic risk and eliminate systematic exposure.
5. Short-selling strategies maintain a net short exposure to the market and attempt to profit from
market declines.
• The market exposure is exactly opposite that of traditional long-only manager.
• Unlike equity long/short managers who typically maintain a net long exposure, short-
selling managers tend to maintain a net short strategy.
6. Distressed security strategies invest in the securities of companies that are bankrupt or are
likely to go bankrupt.
• Capital structure arbitrage is a form of a distressed security strategy that is based on
the hierarchy of claims in a bankruptcy liquidation.
• There is an overlap with private equity investing when distressed security hedge funds
purchase undervalued securities that may appreciate as a result of the bankruptcy
reorganization process.
7. Merger arbitrage involves purchasing the stock of a firm that is the target of a takeover and
selling the stock of the acquiring firm in an attempt to capture the spread between the pre-
merger and post-merger prices of the companies.
• The main sources of return include the (positive) change in value of the target firm
and the (negative) change in value of the acquiring firm.
8. Event-driven strategies attempt to profit from mispricings associated with one-time company-
specific events. The main source of return is from the accurate prediction of the occurrence of
an event within the given time frame of the investment.
9. Fixed-income arbitrage strategies involves taking a long position in one fixed-income security,
a short position in a related fixed-income security, and profiting as the spread between the two
securities converges over time.
• Any type of fixed income security may be used in the execution of the strategy.
• The sources of return come from spread trades (exploiting differences in price
between two otherwise identical securities) and yield curve trades (exploiting
changes in the slope of the yield curve).
• Mortgage-backed security arbitrage strategies attempt to capitalize on pricing
discrepancies in the MBS market.
• The main risk exposures for MBS include duration, convexity, yield curve rotation,
prepayment risk, credit risk, and liquidity risk.
10. Convertible bond arbitrage strategies consist of going long in the company’s convertible bonds
and hedging the associated equity exposure by taking a short position in the company’s
common stock.
• The hedge ratio (delta) determines the appropriate mix of convertible bonds to short
positions in the underlying stock.
• The components of total return include interest on the bonds, short rebate, change in
the value of the bond net, the change in the value of the underlying stock, and interest
on borrowing.
• The main risk exposures are leverage, liquidity risk, interest rate risk, model risk,
credit risk, call risk, and event risk.
• The number of shares that we need to short sell to delta hedge a position is calculated
Shares of stock = number of convertible bonds × conversion ratio × hedge ratio
11. Market neutral strategies take long and short positions securities with the goal of eliminating
all market risk, leaving security selection as the sole source of return.
• The rule of one alpha says that there is only one source of risk-adjusted return.
• Dollar neutral refers to holding equal amounts of long and short positions so the
manager has a zero net exposure to the market.
• Factor models are complex regression equations that relate security returns to one or
more specific variables.
12. Statistical arbitrage strategies rely on complex quantitative models to create convergence
trade portfolios.
• Statistical arbitrage strategies are often called black boxes because they lack
13. Relative-value arbitrage is a broad term that describes any strategy that attempts to profit from
a relative mispricing between two securities.
• Market risk can be removed by holding a long position in one security and a short
position in a similar security.
• Stub-trading strategies are stock-based strategies that involve the piece of an equity
security that is left over from a merger or recapitalization.
• Volatility arbitrage strategies attempt to capitalize on differences in the implied
volatility that exists between option prices on a particular stock.
14. Global macro strategies look for opportunities anywhere in the world and will invest in any
country or any type of security. Global macro managers have the most extensive investment
universe of any manager in that they can invest in anything, anywhere.
15. Funds of funds are opportunistic strategies that invest in portfolios of various hedge funds
• The advantage to a fund of funds is reduced risk as the result of diversification. The
disadvantage to a fund of funds is a double layer of fees for the investor.
20. Establishing a Hedge Fund Investment Program

1. Research on historical performance covering the period from 1989 to 2000 indicates that
hedge funds have consistent positive performance, although not all hedge fund categories
outperformed the S&P 500.
2. Hedge funds generally have less volatility, as measured by standard deviation, than the S&P
3. Studies found that adding hedge funds to a broad stock market based portfolio was found to
increase returns and reduce risk.
4. Hedge funds exhibit low correlation with traditional asset classes, which indicates that adding
hedge funds to a portfolio offers significant diversification benefits.
5. The academic evidence on hedge fund performance has the following drawbacks:
• Majority of studies only covered a 6-year timeframe and did not include performance
in a variety of economic environments. Since this time, the hedge fund industry has
grown exponentially.
• Studies took place before the downfall of LTCM, which showed that shocks to one
hedge fund strategy affect other hedge fund strategies as well.
• Results from performance databases have survivorship, catastrophe, and self-
selection biases which serve to bias reported performance higher and measured
downside volatility lower.
6. Studies concerning performance persistency had mixed results.
7. Hedge funds do not cause financial market calamities but may exacerbate the magnitude of a
market decline.
8. Two primary goals of a hedge fund investment program are to increase return and decrease
9. An opportunistic hedge fund investment program seeks to expand the investment opportunity
set for money managers.
10. Two primary goals of an opportunistic hedge fund investment program are to add value to an
existing investment program through specialization and fill gaps in the investment spectrum of
an existing portfolio.
11. A hedge fund of funds program combines a portfolio of individual hedge funds in an effort to
diversify away the idiosyncratic risk from any one manager.
12. Hedge fund of funds experience declining marginal diversification benefits after five individual
13. Risk budgeting is the process of defining an acceptable amount of risk and then allocating that
risk across a portfolio.
14. Hedge funds tend to be a useful tool for risk budgeting as a result of their low standard
deviation and low correlation with traditional asset classes.
15. Given a risk budget and the standard deviation and correlation between two assets,
appropriate asset class weightings for risk budgeting purposes can be found through the
following formula:

16. The formula for calculating a hurdle rate is . If an asset class’s

expected rate of return is greater than the hurdle rate, the asset class will be a useful tool for
risk budgeting.
17. A portable alpha strategy is a way to transport the alpha from hedge fund of funds investment
to another asset class by investing directly in the fund of funds and using futures contracts to
gain the desired asset class exposure.
18. A hedge fund of funds can be an effective replacement for either cash or bonds in an
efficiently allocated portfolio.
19. Absolute return hedge fund strategies attempt to earn positive returns regardless of the
direction of the financial markets.
21. Due Diligence

1. Due diligence is a disciplined approach for finding the best possible hedge fund manager. The
due diligence process consists of seven parts:
• Structure of the hedge fund
• Investment strategy review
• Performance review
• Risk assessment
• Administrative review
• Legal review
• Checking references
2. Three fundamental questions to ask in order to understand a hedge fund’s investment
program are the following:
• What is the hedge fund manager’s investment objective?
• What is the hedge fund manager’s investment process?
• What is the hedge fund manager’s competitive advantage?
3. Three essential questions for understanding a hedge fund manager’s investment process are
the following:
• What is the hedge fund manager’s investment universe?
• What is the general investment strategy of the hedge fund?
• Does the hedge fund manager have a benchmark, and if so, what is it?
4. A black box investment process uses a quantitative computer algorithm preprogrammed by
the fund manager to make investment decisions.
5. Process risk is an unquantifiable idiosyncratic risk of the fund manager’s structure and
6. Hedge funds gain a competitive advantage through their ability to either filter or gather
7. The structural review phase of the due diligence process allows an investor to define how the
hedge fund is organized as a business entity.
8. A master trust structure is used to invest a hedge fund’s assets in a way that accommodates
the various tax domiciles of the fund’s domestic and foreign investors.
9. A master trust structure has no direct tax consequences, which allows any tax liability
associated with investing in a hedge fund to fall under the tax code of each investor’s home
10. To identify how a hedge fund is organized, an investor should ask the following questions:
• Where is the hedge fund manger located?
• May I see an organization chart of key personnel?
• What is the educational background and prior experience of the firm’s principals?
• How did you learn to short stocks?
11. The CFO of a hedge fund is responsible for reporting the fund manager’s performance results
to investors.
12. An investor needs to know who owns the hedge fund manager in order to assure that
contracts are being signed with the right key people and that interests are aligned effectively
between the fund manager and its employees.
13. In the United States, common regulatory registrations are with the SEC and the NFA/CFTC.
14. Important outside service providers to hedge fund managers are outside auditors, prime
brokers, and legal counsel.
15. Prime brokers are responsible for executing trades, lending securities to sell short, and
providing the means for the hedge fund to leverage its positions.
16. A hedge fund’s investment style, the target markets a manager invests in, and the type of
securities a manager invests in should be documented in order to fully understand the
manager’s investment strategy.
17. A short volatility strategy involves taking short positions in call or put options so that rising
volatility in the price of the underlying security exposes the investor to the risk that the options
could be exercised against the investor.
18. Passive benchmarks are difficult to use for evaluating hedge fund performance because:
• Passive benchmarks are ineffective for measuring the level of a manager’s skill.
• Hedge fund strategies such as a long/short strategy cannot be captured by a long-
only benchmark.
• Concentrated portfolios look much different than broad-based security benchmarks.
19. Hurdle rates are appropriate measures of performance for absolute return hedge funds whose
returns do not relate to the performance of any one sector or market.
20. A portfolio snapshot lets a potential investor see exactly what positions a manager is currently
holding in the hedge fund portfolio and gives insight into the manager’s strategy.
21. The process used for idea generation is a key component of a hedge fund’s competitive
advantage and is reflective of the hedge fund manager’s skill.
22. Capacity refers to the amount of assets under management a hedge fund manager can
handle and still implement the fund’s investment strategy effectively.
23. Three relevant questions to ask when reviewing a hedge fund manager’s performance are the
• How long has the hedge fund manager been actively managing a hedge fund?
• Have performance results of the fund shown persistency over time?
• Are performance results the same or different for each hedge fund the manager
24. Drawdown refers to a decline in the NAV of a hedge fund.
25. Drawdowns in long-only investments can be attributed to a decline in the market; however,
drawdowns in hedge funds can only be attributed to a loss of fund manager skill.
26. Withdrawals can have a harmful effect on hedge fund performance by triggering transaction
costs and skewing the asset allocation of the hedge fund portfolio.
27. Three relevant questions for the risk review phase of due diligence analysis are the following:
• What risks are managed by the fund manager?
• How does the fund manager measure risk?
• How does the fund manager manage risk?
28. Active risk is defined as the standard deviation of the difference between portfolio returns and
the returns of a benchmark.
29. Short volatility risk refers to the risk that rising volatility in the prices of underlying securities
could cause short call or put options to be exercised against the fund manager.
30. Counterparty risk is the risk that the person on the other side of a derivative transaction will
default on the agreement.
31. Leverage limits are an effort to limit risk by placing an upper bound on the amount of leverage
a hedge fund manager can use.
32. The administrative review phase of the due diligence process looks at operational issues that
may impact the hedge fund manager and the manager’s relationship with clients.
33. Employee turnover forces a hedge fund manager to spend time and resources finding and
training new employees and is a distraction to the risk management process.
34. The account representative is the investor’s link for handling issues related to setting up
meetings, handling withdrawal requests, processing checks, and conveying performance
35. Disaster planning gives the hedge fund manager a course of action for continuing to manage
the fund in the event that a disaster shuts down a fund’s trading and operations.
36. The limited partnership structure of a hedge fund requires the manager to invest alongside
investors, thus aligning manager and investor interests. Limited partners are at risk in a hedge
fund only to the extent of capital they have invested in the fund.
37. Separate accounts lack the advantages of the limited partnership structure but serce to
eliminate concerns related to withdrawals and proportionate gain/loss reporting.
38. A 2 and 20 fee structure means that the manager receives a consistent 2% management fee
plus 20% of all profits generated by the fund.
39. Having a high watermark means that a fund manager cannot receive a profit-sharing fee until
the manager exceeds the highest NAV for the fund during the previous performance reporting
40. An incentive fee gives the fund manager an incentive to make profits for investors by allowing
the manager to share in a percentage of those profits.
41. Clawbacks allow investors in a hedge fund to take back incentive fees previously received by
the fund manager.
42. A lock-up period refers to a set period of time that an investor’s funds must remain with a
hedge fund.
43. Having a lock-up period is advantageous to investors because it (1) gives the fund manager
time to implement the investment strategy without worrying about redemptions and (2)
temporarily eliminates the problem of transaction costs caused by withdrawals.
44. A notice period refers to a certain period (30 to 90 days) of advance warning for the fund
manager that an investor wants to make a withdrawal.
45. High subscription amounts give the hedge fund manager adequate capital to implement the
fund’s investment strategy and ensure that only sophisticated investors that have a large net
worth invest in the fund.
46. Maximum subscription amounts prevent one investor from having too large of a position in the
fund and can help manage capacity constraints with regard to assets under management.
47. Potential sources of due diligence reference checks include primary service providers and
existing clients.
48. Asking questions to existing hedge fund clients gives an idea of the manager’s quality of
services and can uncover any issues the clients may have that cause dissatisfaction with the
fund manager.
22. Risk Management

1. Academic studies have found that the returns on hedge funds are more affected by the
actions of the manager than by the market. The lack of correlation with traditional financial
assets means that adding hedge funds to an already diversified portfolio can reduce risk and
increase returns.
• Sharpe (1992) reports that traditional asset classes explain about 90% of mutual fund
• Fung and Hsieh (1997) find that traditional asset classes explain approximately 25%
of the variability in hedge fund returns, while hedge fund trading styles explain
approximately 45%.
• Fung and Hsieh (2002) report a large range for R-squares for mapping hedge fund
returns to traditional long only indices, which indicates that traditional mean variance
analysis does not fully capture the return distribution.
• Liang (1999) reports that asset class selection is responsible for 77% of the returns for
emerging markets’ hedge funds but only 20% of the returns for foreign exchange
hedge funds.
• Schneeweis and Spurgin (1998) report that asset classes explain about 67% of the
returns of hedge funds with primarily a long equity strategy and almost zero for
relative value hedge funds. This supports the perception that hedge fund returns are
driven more by the managers’ trading styles than by traditional asset classes.
2. The major risk affecting market directional funds is exposure to the stock market. Market
directional funds include the following strategies: equity long/short, short selling, equity market
3. The major risk of the corporate restructuring funds is the failure of the proposed transaction
(i.e., event risk). Corporate restructuring funds include the following strategies: distressed
securities, merger arbitrage, and event driven.
4. Like corporate restructuring funds, the major risk of convergence trading funds is event risk.
The event for these types of funds is that the prices of two similar securities will converge over
time. Convergence trading fund strategies include fixed-income arbitrage, convertible bond
arbitrage, equity market neutral, statistical arbitrage, and relative value arbitrage.
5. Because opportunistic funds invest in a broad spectrum of investment vehicles, they should be
more diversified than other hedge fund strategies. The major risk is that the hedge fund
manager is not able to create a diversified portfolio and that the return distribution will be
negatively skewed and leptokurtic. Opportunistic funds include global macro strategies and
fund of funds strategies.
6. Convergence trading and corporate restructuring funds are exposed to event risk and
therefore should have large downside risk exposure that is reflected in a distribution that is
negatively skewed with fat tails (leptokurtic).
7. Convergence trading and corporate restructuring funds should exhibit return distributions that
are negatively with fat tails. Funds that minimize market and credit risk exposure (equity
market timing and market neutral strategies) should have low values for skewness and
8. All three market discretional hedge funds return distributions exhibit positive skewness, which
is an indicator of management skill. Both the equity long/short and short-seller indices have a
value for kurtosis that is greater than the market index, while the market timing index value for
kurtosis is negative (platykurtic). The long-only manager has one source of alpha – the ability
to identify underpriced investments to purchase. Likewise, the short-only manager has one
source of alpha – the ability to identify overpriced investments to short. The long-short
manager thus pursues a double alpha strategy by identifying overpriced investments to sell
short and underpriced investments to purchase.
9. The funds with corporate restructuring strategies are all negatively skewed and leptokurtic.
The funds with merger arbitrage strategies have more consistent returns but are also greatly
impacted when the proposed transactions fail to occur (i.e., highest value of kurtosis of all
hedge fund strategies).
10. All of the convergence trading funds have consistent returns in the 0% to 2% range. The fixed-
income arbitrage and relative value strategies are exposed to high amounts of event risk,
while the market neutral funds have very little event exposure and are positively skewed.
11. Global macro funds and FOF fund are able to diversify across broad spectrums of
investments. The global macro managers have been able to produce returns that are
positively skewed with lower values of kurtosis, whereas the returns of FOF managers were
negatively skewed and had fat tails.
12. Market directional hedge fund strategies (equity long/short, short sellers, and market timers)
have positively skewed returns and also are exposed to the most market risk.
13. The equity long/short hedge fund managers expose investors to slightly more event risk than
the S&P 500, but with positive skewness. The hedge funds of market timers exhibit positive
skewness and negative kurtosis. Therefore, market timers are able to reduce event risk. The
hedge funds of short sellers also exhibit positive skewness but have the most volatility and a
negative Sharpe ratio.
14. Most of the convergence trading and the corporate restructuring types of funds are exposed to
event risk. The event risk to these funds is similar to that of an insurance company selling
insurance. That is, insurance companies are able to keep the premium from selling insurance
unless the event that is being insured happens.
15. The convergence trading and corporate restructuring funds have a known upside return;
however, the downside outcome can occur if some event prevents the transaction or the price
convergence to occur. Therefore, these strategies are like selling insurance or selling a put
16. The equity market neutral and equity market timing hedge fund strategies have very low
market risk and insurance risk. Both strategies have very low values for skewness and
kurtosis. The low values for kurtosis indicate that the insurance risk or event risk is very low.
17. Process risk is the inability to examine, understand, or even determine the process used by
the hedge fund manager in selecting investments. Process risk is associated with the manner
in which investments are selected. Just like the unsystematic risk of common stocks, process
risk can be managed by diversifying across several hedge fund managers. Studies by Park
and Staum and by Henker find that investors who combine 15 to 20 hedge funds eliminate
about 95% of the process risk.
18. Mapping risk is the uncertainty associated with determining and measuring sources of risk
because the manger’s strategies and positions are unknown. A suggested solution is for the
hedge fund manager to report the information to a central prime broker, who would
accumulate and report the data without including the names of the specific managers..
19. Transparency risk is the inability to know the trading patterns of a hedge fund manager.
20. There are three potential problems associated with lack of transparency:
• Authenticity
• Monitoring and measuring
• Determining the effect on total portfolio risk of including an allocation to hedge funds
21. Value at risk (VaR) is defined as the maximum loss over a period of time at a given level of
22. Risk management risk is the risk that risk is being measured and managed incorrectly.
23. There are four primary concerns with applying VaR to hedge funds:
• VaR is difficult to compare across hedge funds
• VaR is not additive
• VaR assumes normally distributed returns
• VaR is the maximum loss given normal market conditions.
24. There is data risk associated with academic studies caused by the prime period and
techniques used by the researchers when
• The studies were performed
• There is no comprehensive database
• The hedge funds index data are inherently biased
• Survivorship bias exists
25. Selection bias refers to the effect of voluntary reporting (i.e., there is a tendency for only funds
with positive results to report). Backfill bias refers to the inclusion of the fund’s historical
(positive) performance when I is added to the index. Catastrophe/liquidation bias refers to the
positive bias associated with the withdrawal from the index of funds that start performing
poorly or sense that they will have to liquidate.
26. Performance measurement risk refers to the inability to accurately measure and, hence,
forecast risk-adjusted performance.
27. Because it is biased on normal distributional properties, the Sharpe ratio does not capture the
event risk associated with hedge funds.
28. Short volatility bias is the result of selling derivatives, which inflates Sharpe ratios by adding
cash and reducing volatility.
29. A volatility event is any event that causes the manager to experience losses from shorting
derivatives, such as call or out options being exercised against the manager
30. Event risk is the risk that a portfolio’s value can be affected by large jumps in market prices.
31. Liquidity risk refers to the hedge fund manager’s inability to raise cash at reasonable rates or
sell assets at regular market prices to meet immediate cash needs.
32. Beta expansion risk occurs when a hedge fund has greater sensitivity to downward market
movements than upward market movements due to selling pressure that results from multiple
managers shorting the same security.
33. Short volatility risk refers to the risk that rising volatility in underlying securities could cause
short put option positions to be exercised against the fund manager. The returns o corporate
restructuring hedge fund strategies tend to suffer when market volatility increases indicating
exposure to short volatility risk.
34. Multimoment optimization incorporates skewness and kurtosis into portfolio optimization
analysis in order to capture the off-balance-sheet risk of the hedge fund manager.
35. Headline risk refers to the fact that the lack of transparency and potential for high returns from
hedge funds make investors susceptible to stories of great returns from fraudulent managers
who want to collect high fees.
23. Regulation of Hedge Funds

1. The Securities Act of 1933 applies to hedge funds:

• The act contains two key provisions that apply to hedge funds. The first provision
requires that a registration statement be filed out with the SEC prior to the initial sale,
and the second provides for exceptions to the registration requirement.
• A limited partnership unit of a hedge fund is considered a security.
• The SEC does not “approve” a registration statement. Rather, a registration statement
is declared “effective” by the SEC when all material information has been disclosed.
• Section 4 of the 1933 Act provides an exemption from the SEC registration process
for private offerings (e.g., hedge fund partnership units)
• Regulation D provides conditions for exemption for hedge funds from SEC filing;
however, it does not provide a safe harbor from antifraud provisions.
• Two key provisions in Rule 501 are the calculation of the number of investors and the
definition of an accredited investor. Rule 506 states that to be exempt from SEC
regulation, there cannot be more than non-accredited purchases or securities. The
number of accredited investors is not limited. Accredited investors are large
institutional investors or high net worth individuals.
• Rule 502 includes an integration provision that states that all sales that are part of the
same offering must comply with all provisions of Regulation D.
• Section 17 subjects hedge fund managers to the anti-fraud provisions, regardless if
the hedge fund is offered as a public of a private offering.
2. The Securities Exchange Act of 1934 applies to hedge funds. The 1934 Act
• Created the SEC as the regulatory body to enforce security laws
• Created regulations and required that all broker-dealers register with the SEC
• Established rules for the secondary trading of securities, including transactions
involving hedge funds. Rule 10b-5 subjects transactions between investors to the
same antifraud standards that the hedge fund issuers are required to follow.
3. The Investment Company Act of 1994 applies to hedge funds.
• “3(c)(1) funds” are exempt from registering with the SEC as long as there are 100 or
less investors in the fund.
• As long as there are less than 500 qualified purchasers in the fund, “3(c)(7) funds” can
avoid the registration and reporting requirements of mutual funds. Section 12(g)(1)
limits the number of investors to 499 for “3(c)(7) funds”.
• The 1996 amendment to the Investment Company Act of 1940 defined qualified
purchasers as:
o A natural person (including a qualified spouse) who owns at least $5 million of
o Owners of a family business who directly or indirectly own at least $5 million.
o Trusts that are not formed for the sole purpose of acquiring securities.
o Any other person who owns or acts for another qualified purchaser who owns
and invests at least $25 million on a discretionary basis.
4. The Investment Advisers Act of 1940 applies to hedge funds.
• Under Section 203(a), an investment adviser can avoid registering with the SEC if he
does not manage more than $25 million, and if he is not an adviser to a mutual fund.
• Under Section 203(b), an investment adviser can avoid registering with the SEC if he
has managed less than 15 clients during the previous 12 months.
• Under section 206, all investment advisers are subject to the antifraud provisions of
the Investment Advisers Act of 1940.
5. The changes to Section 203(b) were intended to increase the regulation of hedge funds.
•Under Section 203(b), an investment advisor can avoid registering with the SEC if the
new advisor has managed less than 15 clients during the previous 12 months. The
new rule requires that each investor in a hedge fund counts as a client. Since most
hedge funds have more than 14 investors, most hedge managers will have to register
as investment advisors.
• The new rule follows for an investment advisor to avoid registering with the SEC if the
advisor does not manage more than $25 million and if he is not an advisor to a mutual
fund. A fund also qualifies for an exemption if it requires a lock-up process of at least
two years.
• The SEC lists four benefits to the more rigorous registration requirements under Rule
203(b)(3)-1 and Rule 203(b)(3)-2:
o Providing census information on hedge funds.
o Deterring fraud.
o Strengthening internal controls.
o Improved monitoring of industry growth and practices.
• Two practical implications associated with the new rule are:
o The costs of a chief compliance officer and other internal controls should not
be a burden to hedge funds due to the large fees charged by hedge funds.
o As more hedge funds adopt 2-year lock-up provisions, the liquidity of
investors is reduced, as well as the ability of regulators to track and regulate
the industry.
6. The Commodity Exchange Act (CEA) applies to hedge funds.
• The rules that relate to Commodity Pool Operators (CPOs) are most relevant to hedge
funds. Managers of hedge funds who are CPOs must register with the Commodity
Futures Trading Commission (CFTC) and the National Futures Association (NFA). In
addition to disclosure, reporting, record keeping, and performance disclosures,
registered CPOs are also subject to audits by the CFTC.
• A CPO is any individual or firm that invests the collective money of a group in the
commodity futures and/or options markets.
• Although there are numerous provisions in the CEA that exempt hedge funds from
filing annual reports, all hedge fund managers are subject to the antifraud provisions
of the CEA.
o Under Section 4.5, hedge funds are exempt from registration if the entity is
subject to regulation by another federal jurisdiction.
o Under Section 4.13(a), a CPO is exempt from registration if he
Does not receive compensation from the pool
Only operates one pool
Does not advertise the pool
Is not required to register under other provisions of CEA.
o Under Section 4.13(b), a CPO is exempt from registration if
The total contributions are less than $200,000
There are no more than 15 participants in the pool
o Under Section 4.7, CPOs must register and file annual reports with the CFTC
and NFA; however, the CPO is exempt from disclosure, reporting, and record-
keeping requirements. This exemption requires that the hedge fund only sell
to “Qualified Eligible Participants” (QEPs) and that it files with the CFTC a
notice of claim for exemption.
o QEPs include most institutional investors (e.g., banks, broker-dealers, other
CPOs, Commodity Trading Advisors, insurance companies, pension plans).
Individuals are considered QEPs if they are accredited investors as defined
under Regulation D, have an investment portfolio of at least $2 million, or
have $200,000 on deposit with a futures commission merchant.
7. The President’s Working Group on Financial Markets made several recommendations for
financial institutions’ risk management practices:
• Establish a procedure to monitor and measure counterparty risk.
• Limit credit exposure to or by any one institution.
• Institute programs to mitigate credit risk
• Define standard valuation practices for derivative securities
• Develop techniques to integrate credit risk and market risk
8. The President’s Working Group on Financial Markets made several recommendations for
enhanced regulatory overview:
• Expand the authority of the SEC, CFTC, and Treasury Department to monitor
counterparties, which would include hedge funds.
• Increasing the risk assessment authority of the SEC and CFTC for unregulated
affiliates of broker dealers and Futures Commission Merchants (FCMs) and the
holding companies they form.
• Requiring reports to credit risk by counterparty for broker dealers, FCM, and their
unregulated affiliates.
9. The President’s Working Group on Financial Markets made several recommendations for
hedge funds:
• Improve transparency by increased frequency of disclosures.
• Publish a set of sound risk management practices.
• Assess performance relative to sound practices for investors and counterparties.
10. The Group of Five Hedge Funds made several recommendations for managing market risk:
• Measure market risk for each hedge fund portfolio and several relevant sub-
• Stress test the impact of market conditions on market risk.
• Backtest the market risk models on historical data.
11. The Group of Five Hedge Funds made several recommendation for managing credit risk:
• Policies and procedures for managing, measuring, and monitoring the exposure to
potential default of counterparties.
• Appropriate levels of collateral and other credit support in the counterparty
12. The Group of Five Hedge Funds made several recommendations for managing liquidity risk:
• Assessment of the impact of specific investment strategies, the terms of redemption
for hedge fund investors, and the liquidity of the assets in the portfolio.
• An evaluation of and borrowing capacity under the worst case historical conditions
and stressed market conditions.
• A forecast of liquidity requirements and likely changes to liquidity measures.
Risk Exposure for Hedge Fund Strategies and Statistical Summary
of monthly returns
Broad Hedge Fund Major Risk Mean Std. Skew Kurtosis Sharpe Comment(s)
Category Strategy Exposure Dev. Ratio
Market Long bias and double alpha
Market Equity
(double alpha 1.36% 2.55% 0.19 1.41 0.38 strategy may explain higher
directional: Long/Short
strategy) kurtosis
exposure – all High volatility (lack of
Opposite of
exhibit Short Selling 0.32% 6.10% 0.14 1.55 -0.01 consistency) contributes to
positively negative Sharpe ratio
skewed Market
Equity Market Negative kurtosis indicates less
returns Minimal use of 1.03% 1.95% 0.09 -0.52 0.32
Timing exposure to outliers
Event risk:
Distressed ultimate credit Volatility is lower than high yield
1.21% 1.75% -0.67 5.69 0.47
Corporate Security risk exposure bonds
Restructuring: (bankruptcy)
event risk from Use of leverage magnifies the
Event risk and
short volatility impact of outliers, but returns
Merger Arbitrage use of 0.82% 1.22% -2.63% 11.64 0.34
strategies are consistent with 76%
results in between 0% and 2%
negatively Ability to invest in events other
skewed, than mergers results in smaller
Event risk and
leptokurtic kurtosis than merger arbitrage,
Event Driven use of 1.17% 1.89% -1.32 4.83 0.41
returns but returns are less consistent
with 50% of returns between 0%
and 2%
Event risk that
Negatively skewed with large
Fixed Income bond prices
0.68% 1.23% -1.72 10.60 0.23 value for kurtosis but with 72%
Arbitrage may not
of return between 0% and 2%
Smaller value for kurtosis than
Event risk that
Convertible fixed income arbitrage – more
company 0.81% 1.03% -1.12 1.96 0.39
Arbitrage consistent with 78% of returns
Convergence redeems bond
between 0% and 2%
Trading: event
Minimize Positive values for skewness
risk from short
market & and low value for kurtosis –
volatility Equity Market
credit 0.74% 0.91% 0.17 0.38 0.38 minimal market and credit
strategies Neutral
exposure with exposure (i.e., all gains from
which are
zero beta security selection)
similar to
Quant models
writing a put
zero out other Low values for skewness and
option or
Statistical risk factors kurtosis. Similar to market
selling 0.69% 1.13% -0.06 0.50 0.26
Arbitrage (e.g., size, neutral strategy except decisions
growth, and are more model driven
Event risk
with short
Negatively skewed with a large
Relative Value value for kurtosis (leptokurtic).
strategy 0.95% 1.04% -0.83 10.51 0.53
Arbitrage Returns are consistent with 76%
magnified by
of returns between 0% and 2%
use of
leverage (e.g.,
investment Able to diversify across asset
spectrum classes and geographic scope.
Global Macro 1.25% 2.40% 0.36 0.57 0.35
creates Returns are close to normal with
diversified positive skew.
diversified so
that returns
Investment in
are Although able to invest in variety
other hedge
symmetrical of hedge funds, the returns are
Hedge Fund of funds should
0.80% 1.61% -0.24 4.34 0.25 negatively skewed and
Funds create
leptokurtic, which is inconsistent
with expectations
S & P 500 Long only 1.01% 4.40% 0.63 0.58 0.14 Negatively skewed
Negatively skewed and
Indices: all SB High Yield Long only 0.75% 2.05% -0.81 4.16 0.17
Negatively skewed and
skewed HFRI Composite Not investable 1.13% 1.98% -0.61 2.90 0.37
24. Introduction to Commodity Markets

1. Commodities are a distinct asset class. Compared to capital assets, commodities:

• Cannot be valued based on discounted cash flows.
• Do not conform to asset pricing models such as the CAPM.
• Trade in a global, rather than regional marketplace.
2. Directly purchasing commodities is a difficult way to gain exposure due to the costs involved
with storing the commodity.
3. Buying shares of natural resource companies that derive the majority of their revenue from
buying and selling a particular commodity is considered a “pure play” on the price of the
commodity. In practice, pure play investments may not work due to market and company-
specific risk factors.
4. Commodity futures are considered the easiest way to gain economic exposure to commodities
because they:
• Trade on an organized exchange.
• Do not require the delivery of actual commodity to close a portion.
• Can be purchased on margin.
5. Commodity-linked notes combine commodity exposure with a traditional debt instrument.
6. The futures price is a no-arbitrage price. For a future of term T on an asset with no storage
costs or expected cash flows over the term of the contract, the futures price is:

7. Cash and carry arbitrage earns an arbitrage profit when the futures contract is overpriced
relative to the no-arbitrage price. It involves borrowing the money to buy the asset (and
holding it), selling the future, and delivering the asset to get the futures price, repaying the
loan, and keeping the difference as arbitrage profit.
8. Reverse cash and carry earns an arbitrage profit when the futures contract is underpriced.
The strategy is to short the asset, invest the proceeds, buy the future, take delivery at maturity
to cover the short, pay the futures price with the loan proceeds, and keep the difference as
arbitrage profit.
9. For a futures contract where the underlying asset pays a known dividend yield, the futures
price is:

10. The price for currency futures is based on interest rate parity, which says that the forward
exchange rate (F), measured in $/unit of foreign currency, must be related to the spot
exchange rate (S) and the interest rate differential between the U.S. and the foreign country
( ). For a foreign currency futures contract, the futures price is:

11. Storage costs increase the effective cost of commodity ownership. For a commodity futures
contract with storage costs, the futures price is
• if the storage costs are expressed as a known cash flow.
• if the costs are expressed as a continuous yield.
12. The convenience yield reflects a monetary or non-monetary benefit from holding a physical
asset. If a convenience yield, Y, is included in the futures pricing relationship, the futures price

13. If a commodity futures contract is overpriced, cash and carry arbitrage can be used to exploit
the arbitrage opportunity. The difficulty in short-selling commodities makes exploiting
undervalued futures prices through reverse cash and carry arbitrage virtually impossible.
14. Normal backwardation refers to a price pattern where the futures price is below the expected
future spot price and converges to that price from below over time.
15. Contango refers to a price pattern where the futures price is above the expected future spot
price and converges to that price from above over time.
16. Hedging allows commodity producers and users to separate their commodity price risk from
their business risk and deploy capital more effectively.
17. The role of speculators in the commodity markets is to accept the price risk that hedgers are
unwilling to bear.
18. Backwardated commodity markets result from hedgers being net short futures contracts.
Hedgers are willing to sell futures contracts at a discount in order to coax speculators to take
the long position in a trade.
19. Contango commodity markets result from hedgers being net long futures contracts. Hedgers
are willing to buy futures contracts at a premium in order to coax speculators to take the short
position in a trade.
20. Speculators are compensated by receiving the discount or premium that hedgers give up
when trading futures contracts.
21. Commodities have a negative correlation with stocks and bonds, which has important
implications for portfolio construction.
25. Investing in Commodity Futures

1. Real assets have a physical existence.

2. The relationship between commodities and capital is characterized by:
• Higher prices for commodities, which increase both inflation and interest rates, which
negatively affect stocks and bonds.
• Prices of commodities that are affected by short-term expectations and stocks and
bonds reflecting long-term expectations.
• A tradeoff between the cost of capital and the cost of raw materials.
• Commodities that are subject to positive event risk because price shocks are usually
in the form of reduction in supply, which result in :
o Positively skewed return distribution for commodities.
o Positive returns for commodities and negative returns for stocks and bonds.
o A reduction in the supply of the commodity to the market.
3. Empirical findings indicate that commodities are an effective hedge for unexpected inflation
and can provide diversification benefits to portfolios of stocks, bonds, and T-bills. Other
empirical findings show that commodities are more effective at hedging inflation than real
estate or the stocks of commodity producers.
4. The characteristics of a desirable commodity index include long positions only (i.e., investable)
and do not include leverage (i.e., no margin purchases) or financial futures.
• Unlike the commodity futures contracts, commodity indices are adjusted so that the
impact of leverage is removed. An unleveraged index is assumed to be fully
collateralized by the purchase of an equal dollar amount of U.S. T-bills equal to the
face value of futures contracts.
• Economic exposure is the potential for gains and losses to the purchaser of a
commodity futures contract as the price of the underlying commodity changes.
• The commodity indices represent unleveraged passive exposure to long positions in
commodity futures, whereas managed futures accounts are levered, actively
managed portfolios of commodity and financial futures.
• The sources of commodity index returns include the price changes, the collateral
yield, and the roll yield.
• Collateral yield is the interest earned on U.S. T-bills used to collateralize the
commodity futures index.
• Roll yield is the holding period return that results from the commodity futures term

• As the time to maturity is reduced, the futures price must converge toward the spot
price; therefore, the roll yield becomes larger as time to maturity decreases (i.e., yield
is more positive for backwardated markets and more negative for contango markets)
5. The GSCI is a long-only, tradable index for physical commodity futures contracts.
• The GSCI is production-weighted, using exogenous economic data to reflect the
importance of each component to the global economy.
• The five groups of real assets in the GSCI are precious metals, industrial metals,
livestock, agriculture, and energy. Energy makes up over 70% of the index.
• The distribution of returns for the GSCI is described as being positively skewed and
leptokurtic, therefore indicating that the exposure to event risk is beneficial to GSCI
6. The DJ-AIGCI is a long-only, diversified index of physical commodities.
• The commodities in the DJ-AIGCI are from the following groups: energy, precious
metals, industrial metals, grains, livestock, and soft commodities (which include
coffee, cotton, and sugar).
• The DJ-AIGCI is weighted primarily by the trading volume of the future’s contracts and
secondarily on production. The index also requires that no group comprise more than
the 33% of the index and that each commodity must represent at least 2% of the
index. Although the index weights are rebalanced each January, the commodity
weights in the index vary based on each commodity’s value. Thus, the index is
momentum-based because of its reliance on the liquidity, as indicated by trading
• The distribution of returns for the DJ-AIGCI is described as being positively skewed
and slightly leptokurtic, therefore indicating that the exposure to event risk is beneficial
to DJ-AIGCI returns.
7. The CRB Index is a naïve index that equally weights each of the 19 physical commodities that
comprise the index.
8. The MLMI allows for both long and short positions in physical commodity, financial, and
currency futures.
• The MLMI invests in 22 contracts, including commodities, financials, and currencies.
• The MLMI is an equally weighted index based on pricing trends over the prior 12
• The distribution of returns for the MLMI is described as being negatively skewed and
leptokurtic, therefore indicating that the exposure to event risk is not beneficial to
MLMI returns.
26. Commodity Futures in a Portfolio Context

1. The positive correlation between commodity futures indices and inflation provides a hedge
against the declining values of stocks and bonds that occur during periods of high inflation.
2. Commodities are a better inflationary hedge tool than TIPS because commodities increase in
value during periods of inflation, while TIPS only preserve the purchasing power of the bond.
Therefore, during periods of high inflation, increases in the value of commodities can offset the
decline in the value of stocks and bonds.
3. Because of their negative correlation with inflation, international stocks do not provide inflation
protection for U.S. stocks or U.S. bonds.
4. Although commodity futures indices are volatile, each of the four commodity indices has low or
negative correlation with the S&P 500, U.S. Treasury bonds, and foreign stocks. Therefore,
commodity futures should be considered in the construction of a diversified portfolio.
5. The efficient frontier is a graph of the best risk-return combinations of risky assets. Each point
on the efficient frontier represents the combination of assets that produces the highest level of
return for a given level of risk or the lowest amount of risk for a given return.
6. Adding a commodity futures index to a portfolio will produce a more efficient portfolio. That is,
for each level of risk, the portfolio’s returns are higher, and for each level of return, the
portfolio’s risk is lower.
7. Adding commodity indices to a portfolio of stocks and bonds produces a more efficient set of
portfolios. Risk-averse investors will benefit most from the inclusion of commodity futures in
their portfolios.
8. Empirical studies have reported an increased correlation among equity markets from different
countries during periods of economic downturns. Higher levels of correlation reduce the
diversification benefits of a portfolio that includes equities from many different countries.
9. An analysis of historical returns indicates that including any of the four commodity futures
indices as a portion of a portfolio of U.S. stocks and U.S. bonds will improve the downside risk
protection of the portfolio.
27. Managed Futures

1. A commodity pool is a collection of investors who combine their funds to invest in the
commodity futures market.
2. Public commodity pools are available to the general public and are required to register with
the SEC. Public commodity pools have low initial minimum levels of investment and are
considered liquid investments.
3. Private commodity pools avoid SEC registration requirements by selling to institutional
investors and to high net worth individuals. Private commodity pools have more flexibility in
implementing investment strategies and have lower brokerage commissions.
4. CPOs hire professional money managers called CTAs to manage the funds in the commodity
5. The CBOT was formed in 1848 and began trading futures on corn and other agricultural
products in 1850. The CME was formed shortly after the CBOT and traded futures contracts
on livestock products. When currencies became more volatile in the 1970s currency futures
were introduced. As futures contracts on debt instruments and equity indices became popular,
additional futures trading strategies were developed by those in the managed futures industry.
6. The standard fees charged by CPOs and CTAs are 2% management fee and 20% incentive
fee, referred to as 2 and 20.
7. The CEA of 1974:
• Set standards for financial reporting, offering disclosure, and record keeping.
• Requires that the CPOs and CTAs register with the CFTC and the NFA.
• Established the role of the NFA to self-regulate the managed futures industry.
8. Empirical research on managed futures reports that:
• Futures managed by CTAs are beneficial to investors.
• Selecting CTAs based on prior performance will be about the same as a naïve
strategy because of the lack of performance consistency for managed futures.
• There are the following empirical results of public versus private commodities:
o Public commodity pools are not attractive investments and are not an
attractive hedge for inflation.
o Private commodity pools have high Sharpe ratios and provide value to a
portfolio of stocks and bonds.
9. A highly skilled CTA will have a distribution of returns that is positively skewed, indicating the
CTA was able to add value.
10. Although the Barclay Agricultural CTA Index is positively skewed, the mean return is lower
than the MLMI; therefore, the performance results are mixed.
11. Although the Barclay Currency CTA Index is positively skewed and the mean return is higher
than the MLMI, the higher value for kurtosis indicates that the results are influenced by
12. Although the Barclay Financials and Metals CTA Index is positively skewed, the mean return
is negative. Therefore, the CTA does not add value to the investor.
13. The Barclay Diversified Trader Index is positively skewed and has a higher mean return than
the MLMI. Therefore, the index may add value to the investor.
14. Including managed futures in a portfolio of U.S. stocks and bonds will not improve
diversification benefits, but will improve the downside risk protection. The addition of a 10%
weight in the MLMI to the portfolio is reported to have more downside protection than any of
the Barclay’s indices.
Index Characteristics

Index Weighting Return Distribution

Index Characteristics Contracts Type Rebalancing Skewness Kurtosis

24 physical
Only long contracts across:
Production-value Weights set one time
positions in precious metals,
weighted using per year in January; no Positive
GSCI contracts with livestock, Leptokurtic
exogenous minimum or maximum (largest)
the least time to agriculture, and
economic data weight
maturity energy, with energy
making up over
70% of the index

19 contracts from
the following
groups: energy,
Constant rebalancing:
precious metals,
Only long in Liquidity data- maximum weight of 33%
industrial metals, Positive Slightly
DJ-AIGCI physical primarily trading per group and a
grains, livestock, (smallest) leptokurtic
contracts volume minimum of 2% for each
and soft
commodities (which
include coffee,
cotton, and sugar)

19 physical
CRB Naive index Equally weighted Rebalanced monthly Positive Platykurtic

Can be long
22 contracs
and short in Equally weighted,
physical based on moving
MLMI commodities, Rebalanced monthly Negative Leptokurtic
commodities average of prior
financials, and
and financial 12 months
28. Introduction to Private Equity

1. The four strategies relating to private equity are venture capital, leveraged buyouts (LBOs),
mezzanine financing, and distressed debt investing.
2. Venture capital involves attracting equity investments in start-up ventures that are unable to
attract capital from traditional bank loans.
3. Important developments in the history of venture capital include the first venture capital fund
(American Research and Development – formed in 1946), Congress’ establishment of Small
Business Investment Companies, the limited partnership concept, allowance of pension
investing in venture capital, and promotion of venture investing by investment advisers.
4. Venture capital returns should earn between a 5% and 7% return over and above the overall
market, when viewed over an entire business cycle.
5. Venture capitalists generally take two rules in the industry: raising capital and investing in
firms. They may also assist in active management of the firm, provide expert advice, and
provide customers.
6. Venture capitalists’ main areas of focus are:
• Business plans.
• Intellectual property rights.
• Prior operating history.
• Start-up management team.
• Legal and regulatory issues.
• Exit plan.
7. Over the past 15 years, there have been three new sources of venture capital funding:
endowments, intermediaries, and individuals.
8. The various venture capital investment vehicles include:
• Limited partnerships.
• Limited liability companies.
• Corporate venture capital funds.
• Venture capital fund of funds.
9. The stages of venture capital financing include:
• Seed financing.
• Venture capital “feeder fund”.
• Mid- or late-stage rounds.
10. An LBO is a way to take a public company private, usually financed by the firm’s assets, cash
flows, debt financing, and/or bank loans. A management buyout (MBO) is an LBO where the
investors are the current management team. Merchant banking is the purchase of non-
financial firms by financial institutions.
11. EBITDA = earnings before interest and taxes + depreciation and amortization.
12. The following are important developments in the history of LBOs:
• 1976 – Kohlberg Kravis Roberts & Co. (KKR) is created
• 1980s – Growth in junk bond popularity, KKR buys RJR Nabisco, Michael Milken
makes his name
• 1990s – U.S. recession, Russian bond default, decline in LBO market
• 2001 – Development of exchange-traded private equity
13. LBO funds are financed through three primary sources:
• Senior debt – 40% to 60% of transaction; provided by banks, finance companies,
insurance companies; expected returns of 400 to 500 bps over LIBOR; payback of
two to three times EBITDA over four to six years.
• Mezzanine debt – 20% to 30% of transaction; provided by mezzanine debt funds,
institutional investors, investment banks; expected total returns of 17% to 20%;
payback of one to two times EBITDA over five to seven years; equity kicker enhances
• Equity – 20% to 40% of transaction; provided by LBO firm, management, equity
component of mezzanine debt; expected total returns of 20% to 40% over five to
seven years.
14. The compound annual return on an LBO is computed as follows:
"#$% &'()*+, &#-.*)

15. LBOs fall under five general categories:

• LBOs that improve operating efficiency.
• Unlocking an entrepreneurial mindset.
• Overstuffed corporation.
• Buy and build strategies.
• LBO turnaround strategies.
16. There are several ways in which an LBO firm earns fees:
• Management fees.
• Profit sharing fees.
• Privatization fees.
• Break-up fees.
• Divestiture fees.
17. LBO funds, venture capital funds, and hedge funds often are structured as limited partnerships
with the fund manager as general partner and sole decision maker. LBO funds tend to have
higher fees, however.
18. The performance of an LBO fund should be compared to other funds with the same vintage
year since they are likely to be in a comparable stage of the LBO life cycle.
19. Corporate governance is a process in which manages of a firm align interests with equity
20. LBOs are less risky than venture capital because the LBO target company has established
products, established management, and a greater likelihood of using an IPO exit strategy.
LBOs are highly leveraged and are therefore highly risky, but highly profitable investments.
21. To have a successful LBO, it is very important that the management of the firm and the LBO
firm have closely aligned interests and a solid business plan.
22. There are three general purposes of mezzanine financing:
• Mezzanine financing to bridge a gap in time (could be associated with a specific
• Mezzanine financing to bridge a gap in capital structure.
• Mezzanine financing to bridge a gap in an LBO.
23. There are key differences between mezzanine funds and venture capital funds:
• Return expectations:
o Mezzanine funds: 15%-20% (or low twenties).
o LBO funds: mid-to-high 20%.
o Venture capital funds: > 30%.
• Mezzanine financing carries a high interest rate.
• Venture capital funds and mezzanine funds are staffed with personnel with different
24. The advantages of mezzanine debt to the investor include high equity-like returns, priority of
payment, schedule of repayment, board representation, and restrictions on the borrower.
25. There are also advantages of mezzanine debt to the borrower:
• Flexibility.
• Semi-equity.
• Lengthening of maturity.
• No collateral has to be pledged with mezzanine debt.
• Less equity dilution.
• Cheaper than common equity.
26. Mezzanine financing generally includes restrictions on senior creditors including subordination
(blanket or springing), acceleration, drawdown, amendment restrictions, assignment,
insurance proceeds commitments, and takeout provisions.
27. There are several ways a distressed debt investor can gain control of a firm through a
• Using distressed debt to recycle private equity.
• Distressed buyout.
• Using distressed debt for a takeover.
28. Factors that contributed to the growth in the distressed debt market in the 1990s include: an
expansion of the number and types of loans being resold, bank risk management techniques
that call for the sale of sub-performing loan assets, rapidly increasing debt levels, and an
increase in start-ups and subsequent failures.
29. Distressed debt investors (vultures) purchase the debt of financially troubled companies for a
cheap price, initiate a turnaround, and either sell the debt after it recovers its market value or
take an equity stake in the company.
30. Chapter 11 bankruptcy can be a long, complicated process and includes the following steps:
• Debtor files for protection under chapter 11 of the U.S. Bankruptcy Code.
• Bankruptcy court freezes default notices from lenders.
• Firm seeks approval of pre-packaged reorganization plan if it exists; if not, firm must
submit plan within 120 days.
• After filing plan, firm has 60 days to gain acceptance by creditors.
• ½ the number and 2/3 value of each claimant class must accept plan to seek court
• If 120- and 60-day periods pass without a plan any party of interest may submit a plan
which, if accepted by the firm, is submitted for court approval.
• If the firm rejects the alternative plan it must submit a new plan and seek approval, or,
alternatively, the court can force a cramdown.
31. There are two main risks of distressed debt investing: business risk and lack of liquidity.
32. A distressed debt arbitrage is conducted by purchasing undervalued distressed debt and
shorting the underlying firm’s stock. The arbitrager waits for the firm’s prospects to improve,
increasing the debt and equity value. Generally, the large bond interest payments and value
appreciation more than offset any losses.
29. Performance Measurement for Private Equity

1. Results from investing in venture capital (VC), LBOs, mezzanine debt, and distressed debt
over the period 1991 to 2005 include the following:
• Returns to VC exceeded that of the S&P 500 and of the other three private equity
classes. The result is as expected as VC firms take on significant business risk.
Returns were asymmetrical, with large positive skewness and kurtosis.
• LBO returns closely tracked that of the S&P 500 up until 2002, after that, LBOs
earned a positive excess return. The return distribution was nearly symmetrical, with
slightly negative skewness and kurtosis.
• The performance of mezzanine debt was mixed, with performance in line with the
S&P 500 in the early 1990s, but underperformance after. Some underperformance is
expected because of the downside protection of the debt component. The return
distribution for mezzanine debt is less negatively skewed than that for high-yield
bonds, reflecting the downside protection of the debt feature and the ability to
participate in equity appreciation.
• Over the period 1991 to 1997, distressed debt earned a premium over the S&P 500,
but underperformed thereafter. Significant events include Russian debt defaults and
the collapse of LTCM. The returns distribution is slightly negative skewed and the
kurtosis is large and positive.
2. Over the 1991 to 2005 period, LBOs and mezzanine debt have the highest Sharpe ratio at
0.40. VC has the next higher at 0.27, and distressed debt is last with a Sharpe ratio of 0.12.
3. Adding each private equity class (VC, LBOs, mezzanine debt, and distressed debt)
individually shifts the efficient frontier up and to the left, indicating the existence of
diversification benefits. The shift was greater for venture capital and the least for distressed
4. Information asymmetry and illiquidity create a disconnect between the value of private equity
investments and the value of the overall market. This disconnect renders the comparison of
private equity returns to an objective benchmark ambiguous. Part of the problem is the
structure of the private equity market.
• Investors use intermediaries to invest their capital since they lack the time or expertise
to act as individuals. This creates information asymmetry in favor of the intermediary.
• Intermediaries pool the assets of investors to purchase closely held, illiquid securities
over which they have investment and valuation discretion. Intermediaries have
incentive, through performance bonuses, to withhold information and manage the
pricing of the portfolio.
• Issuers are young firms with little publicly known information. This results in
information asymmetry whereby the issuer has better information than intermediaries
or investors. Securities are thinly traded if at all.
• Information processors exist to reduce information asymmetries. Information
processors assess the presence of stale or managed pricing in intermediaries’
reported performance.
5. Stale pricing occurs when the book value of a private equity investment does not reflect the
current market value.
• Conservative intermediaries waiting for objective market events before repricing may
carry stale prices on their books.
• Stale prices lag the general public market resulting in low correlation and volatility
6. Managed pricing occurs when intermediaries quickly mark up the value of the private equity
portfolio after a gain and slowly mark down the portfolio after a loss.
• Performance incentives and the need to raise additional capital from investors often
give rise to managed pricing.
• Managed prices lag the general public market and, like stale prices, create problems
using the CAPM model.
7. Gompers and Lerner recommend overcoming stale or managed pricing by periodically
(quarterly) marking private equity portfolios to market. They tested their theory using the
CAPM regression analysis and found marking to market reduced the excess return (:)
estimate but increased the explanatory power of the model.
8. Beta estimates (market risk exposure) for private equity investments can be determined using
the following regression model:

RMt in the preceding equation represents the market return. The NASDAQ, Russell 1000,
Russell 2000, S&P 500, Salomon Brothers Cash Pay High Yield Index, and Salomon Brothers
Convertible Bond Index were used as market proxies.
9. Excess risk-adjusted return is the return earned by the manager in excess of the risk-free rate,
the market return, and any return attributable to random events. The one-period regression
model can be rearranged to isolate the term :, which represents excess risk-adjusted return
(also known as manager skill) without adjusting for stale or managed prices.

10. We can adjust the excess risk-adjusted return estimate for stale or managed pricing by using
a regression model with lagged excess market return (i.e., lagged market return minus lagged
risk-free rate). The term in the lagged multiple-period model has the same interpretation as the
one-period :.

11. Excess risk-adjusted return estimates from the single-period and multiple-period (using three
lagged quarters of market returns) regression models are directly comparable. In summary,
alphas for each private equity asset class declined from the single regression to the multiple
regression case. Based on the multiple regression results, it appears that LBO, mezzanine
debt, and distressed debt managers provide some positive alpha based on skill and that VC
alphas are due more to random events.
12. R measures the variation of the dependent variable (private equity returns) explained by the
independent variable(s) (market returns). R for the multiple-period regressions were higher
than those for single-period regressions indicating the presence of stale and managed pricing.
13. To determine whether non-synchronous pricing is the result of stale or managed pricing,
dummy variables are introduced into the multiple-period regression model.

Two regressions are then run and compared:

• Regression 1 (up market): D equals zero if the market is down and one if the market is
• Regression 2 (down market): D equals one if the market is down and zero if the
market is up.
• If the beta estimates from the two regressions are asymmetric, managed pricing
• If up-market betas are greater than down-market betas, private equity managers are
slow to mark portfolios up and follow the principal of conservatism.
• I down-market betas are greater than up-market betas, private equity managers are
quick to mark portfolios up to enhance their performance.
14. Regression results to test for managed pricing reveal that each private equity asset class
exhibits evidence of managed pricing, primarily based on asymmetric lagged beta results.
30. Trends in Private Equity

1. The private equity market has evolved from single sourced deals to an auction market where
multiple private equity firms compete for deals in a bidding process. The development of an
auction market reflects:
• A more efficient and mature market where more capital leads to more competition,
which in turn leads to lower returns for investors.
• The potential for less efficiencies as private equity firms have less time to conduct due
diligence and get to know the management of the firms they are doing deals with.
2. Club deals occur when multiple firms work together on a single deal to share costs, present a
business plan, and contribute capital.
3. Advantages of club deals include the following:
• Limiting the auction process to allow a target to be acquired for a more attractive
• Bringing in diverse knowledge or skills to potentially enhance the value of a target
• Diversifying risk.
4. Disadvantages of club deals include the following:
• Lack of opportunity in the marketplace.
• Lack of defined leadership for the business plan of the private equity deal.
• Allowing weak firms without independent deal flow to attach themselves to other
companies’ deals.
5. The secondary market for private equity exists at both the private equity firm and individual
investor level.
6. Advantages of the development of a secondary market include the following:
• Providing liquidity to investors.
• Providing a more effective way to diversify private equity investments.
• Earning positive returns from private equity investments more quickly.
• Creating a way to establish a relationship with general partners in order to gain
access to future deals.
7. Disadvantages of the development of a secondary market include the following:
• Secondary buyouts may reflect too much money chasing too few deals.
• Incentive fees reduce value for investors.
• Increased efficiency and competition reduces return for investors.
8. BDCs are a unique type of closed-end mutual fund that was created to promote investments in
small private businesses. Factors that allow BDCs to compete with traditional private equity
investments include the following:
• Providing significant fee income for the private equity firm.
• Providing investors the opportunity to earn returns that exceed the returns for
traditional bonds.
• Giving investors a liquid market since shares of the BDC trade on a public exchange.
9. The deal terms of hedge funds have a number of advantages over private equity firms:
• Hedge funds can receive incentive fees at any time, while private equity funds only
receive incentive fees after returning capital to investors.
• Hedge fund incentive fees are based on changes in NAV, while private equity fund
incentive fees are based on realized profit.
• Hedge fund incentive fees are collected on a regular basis (e.g., quarterly).
• A hedged fund does not need to recoup management fees before paying incentive
fees, while a private equity fund does.
• Hedge funds typically do not have provisions for the clawback of management or
incentive fees, while private equity funds do.
• Hedge funds typically target a return in excess of cash (i.e., LIBOR + 5%), while
private equity firms try to achieve returns greater than 20%. Having a lower target
return allows hedge funds to be more aggressive in the bidding process.
10. Leveraged loans refer to loans made to borrowers who do not carry an investment grade
credit rating.
11. The rapid growth in the market for leveraged loans has been influenced by both private equity
firms and collateralized loan obligation funds.
• Private equity firms have a great deal of experience dealing with banks and other
fixed income investors to finance their buyouts, which provides a natural entry into the
leveraged loan market.
• Collateralized loan obligation funds give investors a means to access the market for
leveraged loans, which is characterized by offering high yields, relatively stable
returns, seniority in the hierarchy of credit claims in the event of default, and low
correlation with traditional asset classes.
12. PIPEs involve the issuance of private equity, convertible notes, or convertible preferred stock
at a discount by a publicly traded company. PIPE securities cannot be sold by the investor
until they are registered with the SEC. The primary reasons for issuing discounted equity are
the following:
• Newly public companies have a small float and do not wish to dilute shareholders.
• Private securities avoid the intense scrutiny of Wall Street analysts.
• The company can control who receives the securities.
• PIPE transaction costs are much lower than those for public securities.
13. Toxic PIPEs involve the issuance of floating convertibles, reset convertibles, reset common
equity, or reset convertible preferred that have a floating conversion rate that increases as the
stock price declines and can cause a death spiral.
14. Toxic PIPEs and death spirals can be prevented through the use of price floor provisions that
limit the increase in the floating conversion ratio.
Private Equity Return Distribution

Average Skewness Kurtosis
Venture Capital 4.13% 11.00% 2.76 14.890
Leveraged Buyouts 3.49% 5.66% -0.03 -0.076
Private Equity
Mezzanine debt 3.00% 4.50% -0.32 1.620
Distressed debt 1.11% 6.05% -0.63 7.050
S&P 500 1.01% 4.40% -0.63 0.580
SB High Yield 0.75% 2.05% -0.81 4.160
31. Introduction to Credit Derivatives

1. There are three types of credit risk:

• Default risk is the risk that the issuer of a bond will not meet required interest or
principal payments.
• Downgrade risk is the possibility that the credit rating of an asset/issuer is
downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO).
• Credit spread risk is the risk of increase in the spread between the yield of the risky
asset and the yield of a risk-free benchmark security.
2. There are two methods for measuring credit risk:
• Credit ratings are given by NRSROs as a measure of an issuer’s credit risk.
• Credit risk premiums refer to the difference between the yield on a risky asset and a
comparable risk-free Treasury security and reflect the compensation an investor
receives for bearing credit risk.
3. There are three traditional methods for managing credit risk:
• Underwriting standards refer to a lender’s process of analyzing a borrower’s financial
position and the industry a borrower operates in before deciding how much money to
• Diversification refers to making loans across multiple industries to reduce the lender’s
risk that every loan in a portfolio will default at the same time.
• Asset sales are the sale of loans to outside parties in order to remove the loan from
the lender’s balance sheet.
4. Credit risky investments have a low correlation with the S&P 500 and U.S. Treasury securities,
and therefore offer an opportunity to diversify a portfolio consisting of traditional asset classes.
5. High yield debt refers to bonds that have a large credit risk premium compared to a
comparable U.S. Treasury bond and typically do not carry investment grade ratings from
6. The return distribution for high yield debt has a high value of leptokurtosis and is negatively
skewed, reflecting significant downside risk as a result of defaults, downgrades, and widening
of credit spreads.
7. The leveraged bank loan market is made up of loans to companies with a credit rating below
investment grade, or loans that are priced at a 150 basis points or greater spread over LIBOR.
8. Leveraged bank loans come in the form of revolvers or term loans.
• Revolvers are lines of credit (with fixed amortization schedules that are) typically used
to back commercial paper programs of financially stable companies.
• Term loans have fully funded commitments with fixed amortization schedules. They
are typically used by companies that have lower credit ratings.
9. There are five key factors that explain the growth of the leveraged bank loan market:
• Convergence of the bank loan and high yield debt markets.
• Increasing role of insurance companies as a result of deregulation.
• Acceptance of bank loans by institutional investors.
• Securitization through CLOs.
• Providing a means for banks to more effectively manage their risk capital.
10. Bank loans have the most consistent returns of the four credit risky asset classes discussed in
this topic review with less negative skewness and less excess kurtosis than the return
distributions for other credit risky assets.
11. Out of the four categories of credit risky investments, emerging markets debt has the most
skewness and the most excess kurtosis, implying the greatest downside risk. However, most
of the downside risk can be traced to emerging markets crises in 1997 and 1998.
12. Distressed debt is debt that has been impaired by default, bankruptcy, or an extremely low
credit rating with a high probability of default.
13. Distressed debt has the most dispersion of any of the risky debt categories we have
discussed, and considerable exposure to event risk.
14. Credit derivatives provide four key advantages to investors:
• Isolation of credit risk.
• Transfer of credit risk.
• Provide liquidity in times of market stress.
• Transparency in credit risk pricing.
15. Both credit outs and credit calls protect against declines in market values as a result of credit
quality deterioration. The key difference is that credit puts provide a cash payment based on
the value of the underlying bond, while credit call options provide cash payments in the form of
additional coupon income.
16. Credit-linked notes (CLNs) offer investors higher coupon interest in exchange for bearing a
portion of the credit risk associated with the note.
17. The buyer of a total return swap receives the total return of a reference asset in exchange for
LIBOR +/- spread, and assumes all credit risk exposure associated with the asset. The seller
of the total return swap retains ownership, but since cash flows are passed to the buyer, the
seller receives a net cash flow of LIBOR +/- spread.
18. A credit default swap (CDS) is similar to an insurance contract and only makes a payment if a
credit event occurs. In the case of a total return swap (TRS), the swap buyer receives the total
return of the reference asset regardless of whether a credit event occurs.
19. Terms negotiated between the CDS buyer and seller include:
• CDS spread.
• Contract size and maturity.
• Payment trigger events.
• Method of settlement.
• Choice of assets to deliver.
20. The ISDA has identified six specific types of payment trigger events:
• Bankruptcy.
• Failure to pay.
• Restructuring.
• Obligation acceleration.
• Obligation default (technical default).
• Repudiation/moratorium by a sovereign government.
21. Four types of risk associated with credit derivatives are:
• Operational risk.
• Counterparty risk.
• Liquidity risk.
• Pricing/model risk.
32. Introduction to Collateralized Debt Obligations

1. The key to the growth of the CDO market is that CDOs give investors, banks, and brokerage
firms the ability to repackage and transfer credit risk. Specifically, the growth of the CDO
markets can be explained by four factors:
• CDOs give investors access to a diversified pool of risky credit assets.
• Credit tranching allows investors to target specific risk exposures.
• CDOs give banks an effective way to manage credit risk.
• Fees earned by asset managers and brokerage firms provide an incentive to
encourage the use of CDOs.
2. The primary difference between balance sheet CDOs and arbitrage CDOs is the motivation of
the entity issuing the security:
• Balance sheet CDOs are issued primarily by banks or insurance companies as a
means to manage the assets on their balance sheet and the associated credit risk
exposure of those assets.
• Arbitrage CDOs are issued primarily by money managers who are seeking to earn an
arbitrage profit between the return on the collateral and the funding costs of the CDO.
3. A special purpose vehicle (SPV)is used to hold the assets in a CDO structure and is legally
separate from the CDO sponsor, meaning that it is not exposed to the parent’s credit risk
(bankruptcy remote).
4. Waterfall refers to the method where cash flows from the CDO collateral flow to the various
tranches in a CDO structure. Collateral cash flows flow in order of seniority where cash is first
used to meet obligations of the most senior tranche and does not flow to the subsequent
tranche until the senior tranche’s obligations are met in full.
5. In a cash funded balance sheet CDO, a bank removes part of its loan portfolio from its
balance sheet by selling and transferring the assets to an SPV, where the SPV uses the
assets’ cash flows to make payments to the CDO tranches.
6. A synthetic CDO uses credit derivatives to gain exposure to the assets collateralizing the
7. There are four key differences between a cash funded and a synthetic CDO.
• Transfer of ownership.
• Use of proceeds from the sale of CDO securities to investors.
• Use of leverage.
• Difficulty in transferring assets.
8. The sponsoring bank and investors can both benefit from the use of a synthetic balance sheet
• The bank reduces risk and frees regulatory capital by transferring risk exposure from
loans to the CDO trust. It also locks in a return equal to the difference between the
bank’s cost of funds and the rate paid by the total return swap.
• Investors can receive higher returns on investment grade securities through the use of
leverage in the CDO structure.
9. Synthetic CDOs using credit default swaps are often called correlations products because the
CDS exposure is tied to the default of more than one bank loan. The higher the default
correlation of the referred loans, the higher the risk of the CDS, and in turn the CDO
10. Ways banks benefit from CLOs include the following:
• Reducing risk-based regulatory capital requirements (most important).
• Increasing capacity for additional loans.
• Improving profitability measures.
• Reducing credit concentrations in particular industries.
• Maintaining positive customer relations.
• Competitive positioning with investors.
11. Cash flow arbitrage CDOs depend solely on the cash flows generated from the collateral pool
to repay the securities sold by the CDO, while market value arbitrage CDOs actively sell
assets in order to make payments to CDO investors.
12. Synthetic arbitrage CDOs are used by investment management firms who try to profit from
receiving a high yield on collateral assets and paying a lower yield on the CDO trust securities,
and use credit derivatives to transfer the risk exposure of a portfolio of assets without any
change in the legal ownership of the assets.
13. A money management firm profits from the spread between the CDO collateral income and
the interest paid to CDO note holders. The money manager may also earn asset management
or transaction fees from this spread income.
14. The three phases of a CDO life cycle consist of the following:
• Ramp up phase, where the CDO manager builds the collateral portfolio.
• Revolving period, where the CDO manager reinvests cash flows and manages the
• Amortization phase, where principal payments are made to CDO security holders.
15. New developments in CDOs use different forms of collateral in a CDO structure to create
exposure to different asset classes and cash flow patterns:
• Distressed debt CDOs use distressed debt as the primary collateral component and
can provide a series of tranches that have an investment grade credit rating even
though the underlying collateral has a speculative grade.
• Hedge fund CDOs are backed by hedge funds of various strategies.
• Collateralized commodity CDOs are backed by derivatives called Commodities
Trigger Swaps (CTS), where payments between counterparties are based on a
commodity index hitting a certain price level.
• Private equity CDOs are collateralized by investments in private equity funds and give
investors the ability to access the private equity asset class through investment grade
• Single tranche CDOs work like a normal synthetic CDO by using a CDS to transfer
risk exposure. However, it is only a specific portion of the collateral portfolio’s risk that
is transferred to investors.
• Unfunded CDOs allow investors to gain credit exposure without paying cash for the
security. The investor effectively takes a position in a CDS where the investor
receives payments as a credit protection seller and must pay the CDO issuer if the
underlying CDO collateral suffers credit losses.
• A CDO squared (CDO ) is a CDO that invests In other CDOs as part of its collateral
pool and is particularly susceptible to model risk as a result of pricing models relying
on two sets of assumptions.
16. Key risks associated with CDOs include:
• Default risk of the collateral backing the CDO (most important risk).
• Downgrade risk.
• CDO default rates.
• Differences in interest payment receipt periodicity.
• Differences in interest payment dates.
• Basis risk.
• Compression of credit spreads.
• Changes in the sharpe of the yield curve.
17. The conflict between maintaining a high weighted average rating factor (WARF) and
maintaining a high weighted average spread (WAS) over LIBOR creates a challenge for the
CDO manager who must balance the goal of having a high credit quality with achieving a high
rate of income.