P1.T3. Financial Markets & Products Chapter 3. Fund Management Bionic Turtle FRM Study Notes

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P1.T3. Financial Markets & Products
Chapter 3. Fund Management
Bionic Turtle FRM Study Notes

DIFFERENTIATE AMONG OPEN-END MUTUAL FUNDS, CLOSED-END MUTUAL FUNDS, AND

EXCHANGE-TRADED FUNDS (ETFS). ..................................................................................... 3
IDENTIFY AND DESCRIBE POTENTIAL UNDESIRABLE TRADING BEHAVIORS AT MUTUAL FUNDS. ... 8
CALCULATE THE NET ASSET VALUE (NAV) OF AN OPEN-ENDED MUTUAL FUND. ........................ 9
EXPLAIN THE KEY DIFFERENCES BETWEEN HEDGE FUNDS AND MUTUAL FUNDS. .................... 10
CALCULATE THE RETURN ON A HEDGE FUND INVESTMENT AND EXPLAIN THE INCENTIVE FEE
STRUCTURE OF A HEDGE FUND INCLUDING THE TERMS HURDLE RATE, HIGH-WATER MARK, AND
CLAWBACK. ...................................................................................................................... 12
DESCRIBE VARIOUS HEDGE FUND STRATEGIES, INCLUDING LONG/SHORT EQUITY, DEDICATED
SHORT, DISTRESSED SECURITIES, MERGER ARBITRAGE, CONVERTIBLE ARBITRAGE, FIXED
INCOME ARBITRAGE, EMERGING MARKETS, GLOBAL MACRO, AND MANAGED FUTURES, AND
IDENTIFY THE RISKS FACED BY HEDGE FUNDS. .................................................................... 17
DESCRIBE CHARACTERISTICS OF MUTUAL FUND AND HEDGE FUND PERFORMANCE AND EXPLAIN
THE EFFECT OF MEASUREMENT BIASES ON PERFORMANCE MEASUREMENT. .......................... 22
2

 Differentiate among open-end mutual funds, closed-end mutual funds, and
exchange-traded funds (ETFs).
 Identify and describe potential undesirable trading behaviors at mutual funds.
 Calculate the net asset value (NAV) of an open-end mutual fund.
 Explain the key differences between hedge funds and mutual funds.
 Calculate the return on a hedge fund investment and explain the incentive fee
structure of a hedge fund including the terms hurdle rate, high-water mark, and
clawback.
 Describe various hedge fund strategies, including long/short equity, dedicated

short, distressed securities, merger arbitrage, convertible arbitrage, fixed income
arbitrage, emerging markets, global macro, and managed futures, and identify the
risks faced by hedge funds.
 Describe characteristics of mutual fund and hedge fund performance and explain
the effect of measurement biases on performance measurement.
Differentiate among open-end mutual funds, closed-end mutual

funds, and exchange-traded funds (ETFs).
Mutual funds and exchange-traded funds (ETFs) are managed
by professional money managers. Although all three types of
funds are managed, there are key distinctions between the three,
including fees to get in and out of the funds, intended holding
periods, operating costs, and investor targets, among other
differences. Investors typically opt to put money in mutual funds
and ETFs for many reasons, including:
 A desire to have investment expertise rather than put the time and effort into the
investment process themselves.
 The general rule that transaction costs are lower for large trades than for small
trades (and by pooling money in mutual funds or ETFs, investors can lower their
costs to buy stock or bond assets).
 Diversification. Investors wanting access to a broad range of assets would have to
buy each stock or bond individually to ensure diversification. For instance, if an
investor wanted to own each stock within the Standard and Poor’s 500 (S&P 500)
equity index, an investor would need to purchase every 500 stocks by himself. The
investor would also have to keep up with which stocks are in and out of the S&P 500
index at any given moment. Instead of purchasing all 500 stocks, an investor could
simply purchase an S&P 500 index fund and be diversified to all stocks in the S&P
500 with just one purchase.
3
Open-End Mutual Funds
Exchange-Traded Funds
Closed-End Mutual Funds
• Number of • Number of • Track and
shares shares is index of
increase or fixed stocks, such
decrease • Trade like a as the S&P
• NAV is stock 500
calculated at • Usually have • Can be
4 p.m. each a market bought and
day value that is sold at any
• Actively and less than the time and can
passively NAV of the be shorted
managed underlying
assets
Open-End Mutual Funds

The key distinguishing feature of open-ended mutual funds is that the number of shares
outstanding increases or decreases each day as investors opt to put more money into the
fund or decide to redeem their shares. Shares in the fund can be bought from the fund or
sold back to the fund at any time. Some important aspects of open-ended mutual funds
include:
 The funds are valued once a day at 4 p.m. When an investor issues instruction to buy
or sell shares, the value calculated at the end of the day is applied to the transaction
made before that time during that day.
 The value of each share is calculated and referred to as the net asset value (NAV)
of the fund. The NAV is simply the total value of the fund’s assets divided by the
number of shares outstanding. To arrive at the NAV of the fund, the fund manager
sums up all the market values of the assets in the portfolio at the 4 p.m. cutoff.
∑
( )= =
ℎ ℎ
Mutual fund companies and other providers of open-ended funds offer many types of open-
ended funds, such as:
 Money Market funds, which invest in fixed income securities with maturities of less
than one year. Most money market funds attempt to keep a NAV of $1. When the
fund drops below $1 NAV, it is referred to as breaking the buck. Breaking the buck
occurs very infrequently. The most recent popularized breaking of the buck occurred
in September 2008 to Reserve Primary Fund. The buck broke because the Reserve
Primary Fund held commercial paper issued by now-bankrupt Lehman Brothers. In
response to the situation, governments stepped in to guarantee money market funds.
 Bond funds, which invest in fixed income securities with maturities of more than one
year.
 Equity funds, which invest in stocks of publicly traded funds (typically).
 Hybrid funds, which invest in more than one type of security (multi-asset fund).
4
The most well-known and used open-ended mutual funds are equity funds. Equity funds can
be divided into two general groups:
 Actively managed fund. An actively managed fund relies on stock selection and
timing skills of the fund manager, such as funds that invest in equities with high
dividend ratios.
o Actively managed funds usually have a higher expense ratio than a passively
managed fund, where the expense ratio is defined as total expenses divided
by total assets.
 Index or passively managed fund. An index or passively managed fund is

designed to track an index, such as the S&P 500 or FTSE 100. The fund buys all the
shares in the index in an amount representative of the index’s weight and generally
accomplishes this goal.
o Although index funds attempt to perfectly track the index of stocks, tracking is
not perfect, as every index fund has tracking error. The average tracking error
of passively managed funds may be around -0.48%. The negative in front of
the 0.48% means that passively managed index funds usually underperform
their associated index by 0.48%1.
o Index funds typically have lower expense ratios compared to actively
managed funds. This is because actively managed funds typically require
fees for their expertise and administrative/trading activities.
The return of closed-end funds can also be affected by front-end and back-end load fees.
 Front-end load fees. A mutual fund charging front-end load fees is imposing a fee
for purchasing into the fund. The fee often goes to the brokers that sell the fund to
investors.
 Back-end load fees. A mutual fund charging back-end load fees is imposing a fee
when the investor redeems shares in the mutual fund. Back-end load fees are
generally an attempt to prevent investors from moving quickly in and out of the
mutual fund, which increases the expense ratio of the fund. Often, back-end load
fees are for a specified period, such as 6-months or 1-year. Once the investor has
met the holding period requirements, back-end load fees typically go away.
Investor interest in open-ended mutual funds has grown quickly in recent years. In 2008,
open-ended mutual funds had $21.7 trillion in total net assets under management (AUM).
That figure has more than doubled since then, ending 2017 at $49.3 trillion. Of the AUM in
open-ended funds, the largest portion is held in equity funds (44% as of the end of 2017).
In terms of AUM with actively managed mutual funds compared with passively managed
mutual funds, actively managed funds have grown from $1.5 trillion in 1993 to $12.5 trillion in
2017. Over the same period, passively managed funds have gone from $28 billion to $3.3
trillion. The growth in passively managed funds has been much stronger because of
investors’ concerns that actively managed funds do not produce better returns than the
market as a whole, while simultaneously imposing higher fees2.
1
A. Khorana, H. Servaes, and P. Tufano, “Mutual fund fees around the world,” Review of Financial
Studies, 22 (March 2009): 1279-1310.
2
See, as an example, S. Ross, “Neoclassical finance, alternative finance, and the closed-end puzzle,”
European Financial Management, 8(2002): 129-137.
5
Total Net Assets of Worldwide Regulated Open-End Funds3
Closed-End Mutual Funds

In contrast to open-ended mutual funds, closed-end mutual funds have a constant number of
shares (unless new shares are issued). Closed-end mutual funds are essentially a regular
company with the purpose of investing in other companies. When an investor buys shares in
a closed-end mutual fund, they are buying a share in the investing company. The price of the
company reflects changes in expected profit and overall supply and demand.
Net asset value. For closed-end funds, two NAVs are calculated.
 The first NAV is the price at which the shares of the fund are trading.
 The second is the fair market value, which is the market value of the fund’s portfolio
divided by the number of shares outstanding. Usually, a closed-end fund’s share
price is less than its fair market value. One would think that if the NAV was higher
than the trading value of a closed-end fund, that arbitragers would bid this
discrepancy away. Research has generally argued that the reason for the persistent
discrepancy is the fees paid to fund managers4.
3
The Investment Company Factbook, 2018, The Investment Company, 2018. Available at
https://www.ici.org/pdf/2018_factbook.pdf
4
See, as an example, S. Ross, “Neoclassical finance, alternative finance, and the closed-end puzzle,”
European Financial Management, 8(2002): 129-137.
6
o The persistent difference between the market value of closed-end funds and the
NAV can also be explained with an example. Assume that an investor is
considering buying into a closed-end fund for five years. The fund is assumed to
pay no dividend and the fund’s return on assets is assumed to be 10%. Without
considering other factors, the fund’s expected value in five years is $161.05.
= $100 ∙ (1 + 0.10) = $161.05
Now, suppose that the closed-end fund charges a management fee of 1% of
AUM. Implied from this 1% is that the fund’s value will grow at 9% instead of
10%. The expected value after five years is then $153.86, or 4.5% less than the
value of the underlying assets.
% = $100 ∙ (1 + 0.09) = $153.86
Thus, one should expect the value of closed-end funds to be less than the value
of their underlying assets.
Exchange-Traded Funds
Exchange-traded funds (ETFs), also known as index funds
or passively managed funds, are funds whose design is to
track an index, such as the S&P 500 or the Dow Jones
Industrial Average. Originally introduced in the U.S. in
1993 and in Europe in 1999, ETFs have fundamentally
altered the way investors invest and money managers
allocate investments.
An ETF is similar to a stock, where some or all of the shares in the ETF are traded on a
stock exchange. This feature makes ETFs more like a closed-end mutual fund. However, a
key difference between ETFs and closed-end mutual funds is that the value of the assets
underlying the ETF is virtually identical to the market price of the ETF, whereas the market
price of closed-end mutual funds is typically priced below their NAV. This equally stems from
the requirement that ETFs be easily exchangeable on the market. If there was even a
noticeable difference between the value of the assets within the ETF and its market price,
this discrepancy would be arbitraged away quickly.
Because ETFs generally have the same characteristics as stocks, it likely comes as no
surprise that ETFs can be bought and sold at any time of the day, unlike open-ended mutual
funds. Exchange-traded funds can also be shorted, just like stocks. Twice each day ETF
holdings are disclosed, providing investors with more information about the assets
underlying the fund. This is quite different than mutual funds, which disclose their holdings
infrequently.
How are ETFs able to achieve much lower expense ratios compared to most mutual funds?
When an investor redeems shares in a mutual fund, managers sell the stocks in which the
fund has invested. They sell the stocks to raise the cash that is paid to the investor. With
ETFs, this is not necessary because another investor is purchasing the shares from the
seller. Generally, the ETF provider does not need to sell the shares. Thus, ETFs achieve
lower transaction costs and by extension lower expense ratios.
7
Identify and describe potential undesirable trading behaviors at

mutual funds.
In the U.S., Europe, and many other countries or political unions, mutual funds and ETFs are
heavily regulated. In the U.S., the regulatory authority is the Securities and Exchange
Commission (SEC). Regulators work to prevent conflict of interest between mutual fund
managers and the assets they purchase on behalf of the funds’ investors. Additionally,
regulators require very detailed financial reporting to prospective investors. Despite being
heavily regulated, mutual fund managers may take part in undesirable trading behaviors that
lower the actual returns of investors.
Late trading
In the U.S., all buy and sell orders in an open-ended mutual fund
end at 4 p.m. Thus, all trade instructions should be with a broker
before 4 p.m. Theoretically for administrative reasons, however,
the pre-4 p.m. trades may not make it to the mutual fund until
after 4 p.m. If there are market developments soon after 4 p.m.,
a trader might call the broker to cancel a trade that was
previously scheduled to be carried out at the price it would have
gone for at the 4 p.m. cutoff. A trader may also call after the 4
p.m. deadline and request that the broker put through a new
trade at that price. Additionally, some brokers have been known
to (dishonestly) accept orders after 4 p.m. This activity is known
as late trading and, although it happens, it is illegal. Regulators
look for this type of activity and attempt to prosecute violations in
an effort to make the financial system fair for all investors.
Market Timing
Although most assets of an open-ended mutual fund trade
actively, not all do. Because of this, the prices employed to
calculate the fund’s NAV may not reflect the most recent
information. Additionally, prices of securities that trade on
overseas markets may also be stale because of time zone
differences. For instance, suppose that it is 3:45 p.m. and
markets have been performing well over the past few hours,
generally up. With the knowledge that some of the prices of the assets are stale, a trader
could probably guess that the value of the mutual fund shares are probably worth (slightly)
more than what the NAV would indicate. The trader could act on this knowledge and
purchase shares in the mutual fund before 4 p.m. Likewise, in down markets, a trader may
wish to sell at 4 p.m. if the trader believes that the NAV slightly overstates the value of the
assets in the fund. This type of market timing is perfectly legal but may need to be very large
to make it worth the trader’s time. Should this activity occur too often, the size of the fund
may be more volatile than it otherwise would be. This type of trading could also lead to costs
for all investors as the fund may have to keep additional cash on hand to accommodate
redemptions. Lastly, regulators may become concerned if special trading privileges are
offered to market timers.
8
Front Running
Front running refers to the practice that individuals with insider knowledge make trading
moves before the knowledge becomes public. For instance, suppose a trader working for a
mutual fund knows that the fund he works for will execute a large trade that may move
markets. The trader will be tempted to trade on his or her own account immediately before
putting through the fund’s trade. For instance, if a fund is going to buy 20 million shares of a
large company stock, the trader might buy 100,000 for his own account before the 20 million
shares are purchased for the fund. The trader could go even further than trading on his own
accounts before the fund trades and pass on this knowledge to preferred customers or other
fund employees. It likely comes as no surprise that front running (also known as tailgating) is
illegal for employees in the fund management industry.
Directed Brokerage
A directed brokerage agreement is an informal arrangement between a mutual fund and a
brokerage house that the mutual fund will use for its trades if the brokerage house
recommends the mutual fund to its clients. This type of quid-pro-quo behavior is generally
not in the clients’ best interest.
Calculate the net asset value (NAV) of an open-ended mutual fund.

Calculating the net asset value (NAV) of an open-ended mutual fund is a three-step process.
First, the managers calculate the market value of each asset in the fund.
= { , …, , }
In the above set, the fund managers calculate the market value for asset i through asset N.
After calculating all the market values, the fund managers sum up all the market values to
arrive at a total market value for the fund.
The third step to derive the daily NAV is to divide the total market value by the number of
shares outstanding.
∑
( )= =
ℎ ℎ
For instance, if the total value of the assets in the fund was $1 billion and if the number of
outstanding shares is 2 million, then the NAV is $500 per share.
$1,000,000,000 $500
( )= = =
ℎ 2,000,000 ℎ
9
Taxes
In an open-ended mutual fund, the investor is responsible for

any taxes as though he owned the securities in the fund.
Likewise, when the fund receives a dividend, an investor is
responsible for his share of the dividend, even if the dividend is
reinvested in the fund. When the fund sells securities, the
investor is responsible for any capital gain or loss, even if the
fund has not sold any of the investor’s shares in the fund.
Adjustments for capital gains and losses

Fund managers and investors must ensure that no double counting occurs. To ensure this,
the purchase price of the shares gets adjusted to reflect any capital gains and losses
accrued to the investor. For instance, suppose an investor purchases shares in a fund at
$100. After the first year, the capital gains are +$20 and after the second year, the capital
loss is -$25. In this instance, if an investor sold shares in the fund during the second year,
the purchase price for tax purposes would be assumed to be $120. Similarly, if the investor
sold his shares in the fund during the third year, the purchase price would be assumed to be
$95 for tax purposes.
Explain the key differences between hedge funds and mutual

funds.
Hedge funds (also known as alternative investments) and
mutual funds differ from each other in a number of
aspects.
Size of the investable assets of an investor
Hedge funds typically use strategies that carry more risk for the average investor. Because
of this, hedge fund investors usually need to be accredited investors. What are accredited
investors? Accredited investors are high-net-worth individuals, banks, financial institutions,
and corporations with the assets and sophistication to accept the risk associated with hedge
funds. Requirements to be an accredited investor differ across the world. In the U.S., an
accredited investor is an individual or entity with at least $2.5 million in investable assets
and/or $250,000 in income over the prior two years.
Mutual funds, on the other hand, generally accept investment money from all types of
investors, including small investors with just a few hundred dollars to large corporations with
hundreds of millions to invest. Often, mutual funds will offer different classes of the mutual
fund shares (such as Class A shares, Class B shares, and so forth) with different investment
requirements and fee structures. For instance, a mutual fund may offer Class A shares to
only institutions that invest $100 million or more in the fund.
Regulations
Hedge funds and mutual funds are subject to different sets of regulations. It is generally
thought that hedge funds are subject to fewer regulations than mutual funds because hedge
funds cater to financially sophisticated (or theoretically sophisticated) individuals. This is not
to say that hedge funds do not have regulations on how they market their products, what
their strategies may be, what their legal liabilities are, and a host of other regulations. With
this acknowledged, mutual funds differ from hedge funds in the following ways.
10
 Redemption: mutual funds or ETFs allow investors to redeem or sell their shares on
any given day. Mutual funds may charge a fee for short-term trading or a back-end
load fee. In contrast, hedge funds often have long lock-up periods. During lock-up
periods, investors cannot withdraw their money.
 Reporting of fund value: mutual funds are required to report their NAV at least once
per day. In contrast, hedge funds have more flexibility in reporting returns monthly,
quarterly, or at some other interval.
 Disclose of investment strategy: while mutual funds must be generally transparent
with their investment strategy, hedge funds generally keep their investment strategy
proprietary, as they consider this a competitive advantage. Hedge funds must
disclose the general nature of their investment activities but keep proprietary
components proprietary. Additionally, as long as it is disclosed, hedge funds may
switch between investment strategies depending upon management’s view of the
economic situation.
 Leverage: mutual funds are generally prohibited from using leverage. In contrast,
many hedge funds may use leverage to increase their potential return.
Fees
Another important distinguishing point between hedge funds and mutual funds is the fees.
Both mutual funds and hedge funds must be completely transparent on fees, although their
fee structures are usually widely different.
 Mutual fund fees. Mutual funds always charge an
expense ratio fee to cover operating expenses. Mutual
funds may also impose:
o Sales charges (front-loaded fee)
o A redemption fee (back-loaded fee when shares
are sold)
o Short-term trading fees for shares that are held less than say 30 to 90 days
o Ongoing service fees, known as 12(b)1 fees, marketing, or other costs.
 Hedge fund fees. Hedge funds may impose a fee of 1% to 3% of assets under
management and some percentage of profits above a hurdle rate. That hurdle rate
might be something like the return on the S&P 500 or the return on the 10-year
Treasury Note. A typical hedge fund fee might be expressed as “2 plus 20%”, which
means that the fund charges 2% per year of assets under management and 20% of
net profit above some hurdle rate. In addition to the fees imposed, hedge funds also
require a lock-up period of typically at least one year. There is considerable debate
about whether the fees imposed by hedge funds are worth it. Certainly, some hedge
funds have done spectacularly well, returning an average of 35% per year over a 20-
year period5, while others have provided returns that were far less spectacular.
5
Renaissance Technologies, founded by mathematics professor Jim Simons, is the hedge fund
referred to here.
11
Differences Between Hedge Funds and Mutual Funds

Hedge Fund Mutual Fund
Size of investor Typically, hedge fund Mutual funds may cater to
investors must be small or large investors, and
accredited investors (in the typically have different
U.S., >$2.5 million in classes of shares depending
investable assets and/or upon the size of the investor
>$250,000 in income for the
past two years)
Strategies Hedge funds have more Can invest in various asset
leeway in their strategies classes, including equities,
and, as long as it is bonds, commodities, and
disclosed, can change other investment options.
investment strategies on a One strategy that is
dime. Hedge funds can also prohibited is the use of
employ leverage, shorting, leverage. Additionally, the
and other riskier financial strategy is fixed by the
maneuvers. prospectus
Risk Can range from very risky to The risk is dependent upon
completely hedged. Hedge the allowable investment
funds are generally options stated in the
considered riskier than prospectus
mutual funds because of the
investment strategies
employed
Regulation Lighter regulation Heavily regulated
Fees Usually higher fees that, Usually has management
including base fees and fees fees as a percentage of
linked to performance of the assets under management
fund and potentially front-end
and/or back-end loaded fees
Length of investment Typically has a lock-up Generally required to allow
period investors to redeem their
shares at any moment, but
can charge a short-term
trading fee or a back-end
load fee
Calculate the return on a hedge fund investment and explain the

incentive fee structure of a hedge fund including the terms hurdle
rate, high-water mark, and clawback.
Return on a hedge fund investment
The net return on a hedge fund investment depends upon the fee structure paid by the
investors. Suppose an investor places $5 million in Hedge Fund A and Hedge Fund B.
Further suppose that both funds charge a “2 plus 20” fee, meaning that the hedge fund
imposes a fee of 2% of assets under management (AUM) and 20% of realized profits. Lastly,
assume that both funds have no hurdle rates to achieve before the incentive fee is paid out.
12
Scenario 1. Suppose in the first year of investment, Fund A earns a gross return of 20% and
Fund B earns a gross return of –10%. Before any fees, the investor’s return on the
investment is 5%.
= 0.5 ∙ 20% + 0.5 ∙ (−10%) = 5%
Now let’s consider the fees paid to the managers of the funds. The fees paid by the investor
to Fund A and Fund B are 5.6% and 2%, respectively, as shown below.
= 2% + 0.2 ∙ (20% − 2%) = 5.6%
= 2% + 0.2 ∙ {−10% − 2%, 0} = 2.0%
. % %
On average, the fee paid by the hedge fund investor is 3.8% (which is ). Net of fees,
the investor’s return is 1.2% (5% - 3.8% = 1.2%).
In the previous example, the fees were calculated separately. What if the 2% plus 20% fee
structure were applied to the overall return of 5% instead of the two investments separately?
The investor would have paid a fee of 2.6% (which is 2% + 0.2 (5% -2%) = 2.6%). In this
instance, the investor’s return is double that of the original return at 2.4% (which is 5% -
2.6% = 2.4%).
In this example, the hedge funds were imposing fee structures of “2 plus 20”. Fees imposed
by hedge funds have been under pressure in recent years, and as such, they are coming
down. Many hedge funds now offer “1.5 plus 15” or even more competitive fee structures.
Fund of funds. In addition to investing directly in hedge funds, an investor may opt to invest
in a fund of funds. What is a fund of funds? Fund of funds is a way for an investor to diversify
across hedge funds by allowing investors to place money in the fund of funds. The fund of
funds then places the investment into multiple hedge funds. Fund of funds managers charge
a fee for this service. A fund of funds hedge fund may charge a fee of 1% of assets under
management plus 10% of the net profits above some hurdle rate. The hurdle rate may
include the management and incentive fees of the hedge funds invested in.
An example of a fund of hedge funds. Consider an example where a fund of hedge funds
divides its money equally between 10 hedge funds. Assume all hedge funds charge a 2 plus
20% fee structure and the fund of hedge funds charges a 1 plus 10% fee structure. At first
glance, one might think the investor would be paying a 3 plus 30% fee structure. In reality,
the actual fees can be higher. Consider the following scenario in the table below where five
of the hedge funds lose 40% before fees and the other five make 40% before fees.
In this scenario, the profitable hedge funds would impose an incentive fee of 20% on the
profit, equating to 38% (which is 0.2 × (40% – 2%) = 7.6 %). The average incentive fee
across all 10 funds is 3.8% (which is (7.6% × 5)/10 = 3.8%).
The 3.8% average incentive fee is not the end of the story. In addition to the incentive fee,
the investor will need to pay the management fee to each of the hedge funds (through the
fund of funds) and the 1% management fee to the fund of funds. In this scenario, the net
return of the investor is –6.8% (which is 3% + 3.8%).
13
Incentives of Hedge Fund Managers

A major difference between hedge fund managers and mutual
fund managers is incentive pay. Outside of losing assets to
manage for poor performance, mutual fund managers generally
have no incentive to perform better than the market, at least
from an investor’s perspective (the company employing the
mutual fund manager may have an incentive pay structure,
though). In contrast to the mutual fund manager, a hedge fund manager has a fee structure
that gives him an incentive to make a profit above some hurdle rate. Essentially, the hedge
fund manager has a call option on the assets of the fund. In practice, this means that hedge
fund managers can increase the value of their option by taking risks that increase the
volatility of the fund’s assets and (hopefully) increase the return of the fund.
14
An example of a hedge fund manager’s incentive. As an example of the incentive

structure of a hedge fund manager, consider this example. Suppose there is a 40%
probability of a 60% profit and a 60% probability of a 60% loss for a hedge fund that charges
the theoretical industry-standard fee of “2 plus 20%.”
In this example, the expected return on the investment is -12%.
= 0.4 ∙ 60% + 0.6 ∙ (−60%) = −12%
Interestingly, although the return is negative, the hedge fund manager still earns a fee from
managing the money (as is the case with mutual fund managers and most other financial
mangers). In this example, the fee income is 13.6% of the assets under management for the
case when the fund earns a 60% profit and 2% if the -60% materializes. The probability-
weighted fee (expected value) is 6.64%, made up of the 2% management fee and the 4.64%
incentive fee. Of course, a mutual fund manager would have also been paid regardless of
the return of the fund.
 60% profit example: the hedge fund’s fee is 2% + 0.2 × 58% = 13.6%.
 60% loss example: the hedge fund’s fee is 2% + 0.2 x 0% = 2%.
 The expected (or probability weighted average) fee to the hedge fund is 0.4 × 13.6%
+ 0.6 × 2% = 6.64%.
The expected return for the hedge fund investors, after accounting for the fees, is -18.64%,
as shown in the table below.
0.4 ∙ (60% − 0.2 ∙ (60% − 2%) − 2%) + 0.6 ∙ (−60% − 2%) = −18.64%
An Example of a High-Risk Investment with a "2 + 20" Fee Structure

Returns 60% -60%
Probability 40% 60%
Expected return to hedge fund 6.64%
Expected return to investors -18.64%
Overall expected return -12.00%
The above table should make one point clear. The fee structure for hedge funds provides an
incentive for hedge fund managers to take high risks, perhaps even when expected returns
are negative. For instance, if one changes the probabilities in the table (see below) to be a
10% chance of a gain of 60% and a 90% chance of a 60% loss, the expected returns for the
investors and the hedge fund managers are -51% and +3%, respectively. The hedge fund
manager’s expected return only drops by a little more than 3% even though his investors’
expected return drops from about -19% to about -51%.
An Example of a High-Risk Investment with a "2 + 20" Fee Structure

Returns 60% -60%
Probability 10% 90%
Expected return to hedge fund 3.16%
Expected return to investors -51.16%
Overall expected return -48.00%
15
Arrangements (or clauses) offered by hedge funds to make high fees more palatable
Since the incentive fee structure and the associated risk of the hedge fund is high relative to
a mutual fund manager with no incentive structure, hedge funds and their clients may agree
to arrangements that include certain clauses to better align incentives. These include,
among others:
 Hurdle rate: Investors may demand that, in order for the hedge fund to earn their
high fees, it must perform better than a specified minimum return. Generally,
investors push for hurdle rates that are as high as possible, sometimes even as high
as the return on the S&P 500. In contrast, hedge funds generally attempt to keep the
hurdle rates low, such as the yield of the 10-year Treasury Note.
 Clawback clause: Clawback clauses are what the name implies – an investor can
“clawback” something. What the “something” is depends on the contract. For
instance, a clawback clause may allow investors to apply for part or all of the
previous incentive fees against current losses. In this case, a portion of the incentive
fees paid by the investor each year is then retained in a recovery account and used
to compensate investors for a percentage of any future losses.
 High-water mark clause: A high-water mark clause requires the hedge fund to
recoup any previous losses before an incentive fee applies. The high-water mark
clause is investor specific, meaning that the hedge fund and each investor will need
to keep track of what the provisions are. For instance, if an investor places $100
million with a hedge fund and the fund loses $10 million, then the managers of the
hedge fund must make $10 million before incentives kick back in.
 Proportional adjustment clause: A proportional adjustment clause states that if
funds are withdrawn by investors, the amount of previous losses that have to be
recouped is adjusted proportionally. In the example used above, if the investor
withdraws $5 million before the hedge fund makes up the losses, the hedge fund
may only need to make up $5 million before the incentive fees apply again.
16
Describe various hedge fund strategies, including long/short

equity, dedicated short, distressed securities, merger arbitrage,
convertible arbitrage, fixed income arbitrage, emerging markets,
global macro, and managed futures, and identify the risks faced by
hedge funds.
Hedge funds use a variety of strategies catered to different
types of investors. Hedge funds may also change strategies
depending upon the belief of the manager.
Long/Short Equity
Perhaps the most popular hedge fund strategy is a long/short
equity strategy. Managers using a long/short strategy take
long positions in a group of perceived undervalued stocks and
a short position in a group of stocks considered overvalued by
the market. In theory, this strategy could provide strong
returns regardless of whether general market conditions are
in bull and bear markets if the stocks are picked up after
being well researched. The long and short positions need not
be of equal size. Often, the hedge fund manager has a net
long bias, meaning that the hedge fund’s long stock
ownership is larger than the shorts. The flip can also be true
should the hedge fund manager have such as bias.
Referring to a fund as long/short captures the broad picture.

There are many different styles underneath this umbrella,
including:
 An equity-market-neutral strategy, which matches
long positions with short positions in some way.
 A dollar-neutral strategy, which takes an
approximately neutral strategy where the amount of the long position equals the
amount of the short position.
 A beta-neutral strategy, which is an equity-market-neutral fund where the weighted
average beta of the shares in the long portfolio equals the weighted average beta of
the shares in the short portfolio. Done correctly, the overall beta of the portfolio is
zero or totally insensitive to market movements. (As a reminder, the beta of a
portfolio is how correlated the returns of a fund are with the overall market.)
 A sector neutrality strategy, where long and short positions are balanced across
industry sectors.
 A factor neutrality strategy, where funds maintain neutral exposure to such factors
as:
o The price of oil,
o The level of interest rates, or
o The rate of inflation.
17
Dedicated Short
Dedicated short strategies are strategies in which the hedge fund managers select stocks
they consider overvalued and sell them short. Hedge fund managers may use this strategy
to take advantage of nuances in the marketplace, including:
 Brokers and analysts are generally less than excited to issue sell recommendations.
If the hedge fund managers think they can trade based upon this incented behavior,
they may generate reasonable returns.
 Shorting companies with weak financial measures, such as market value to book
value, earnings growth, or other financial measures.
 Shorting companies that change their auditors regularly.
 Shorting companies that delay filing reports with the U.S. Securities and Exchange
Commission.
 Shorting companies in industries with perceived overcapacity, which may lead to
profit pressure.
 Shorting companies attempting to silence their short sellers.
This list of potential reasons hedge fund managers may short a company is not intended to
be exhaustive, but rather an indication of some of the reasons hedge fund managers make
the investment decisions they make.
Distressed Securities
Bonds with a rating of BB or lower are referred to as “non-
investment grade” or “junk” bonds. Bonds with a credit rating
of CCC are known as “distressed”. Bonds with a D rating are
in default. There are important points to consider when
thinking about distressed security investing, addressed below.
 Distressed debt cannot be shorted. The nature of
distressed debt is that there are no takers for potential
shorting. This means that hedge fund managers
cannot bet on the debt dropping further. Instead of
shorting, hedge fund managers usually look for debt
that the managers consider undervalued by the
market.
 Bankruptcy laws must be known. When dealing with
distressed debt, one has to know that any investment is one step away from
bankruptcy. Because of this, distressed debt hedge fund managers must be well
versed with bankruptcy proceedings, including reorganization, liquidation, recovery
rates, prioritization, and other factors that would determine whether the hedge fund,
as an owner of bond debt, would get paid in the event of a bankruptcy.
 Passive managers take one type of risk. Passive hedge fund managers buy
distressed debt when managers think the price is below its fair value and generally
hold it. The advantage of a passive approach, compared to an active approach, is
that the fund generally places smaller bets on the distressed company.
 Active managers take another type of risk. Active managers, in contrast to
passive managers, may buy a large position in outstanding debt so that they can
influence any potential reorganization proposal. The risk with this is that the hedge
fund is placing more assets at risk for greater control of the assets in case
bankruptcy occurs.
18
Merger Arbitrage
A merger is when one company combines with another company. Mergers can be friendly or
contested. Typically, when a potential merger is announced, there is uncertainty about
whether the merger will go through. Some roadblocks might be shareholder resistance,
regulatory concerns, and anti-trust considerations. Merger arbitrage is when an investment
manager makes “bets” on whether a merger will go through after it has been announced. In
terms of returns, merger-arbitrage hedge funds generally produce reasonable, but not
massive, returns.
Mergers arbitrage can be divided into two main types of deals:

 Cash deal. Consider a cash deal in which Company Gamma announces that it plans
to acquire all shares of Company Epsilon for $50 per share. Prior to the
announcement, suppose the shares Company Epsilon were trading at $42 and
immediately after the announcement the price jumps to $48 per share. Why did the
price not rise all the way to $50 per share? Well, there is uncertainty about whether
the deal will go through. It may also take time to factor into market prices. Merger-
arbitrage hedge funds buy the shares in company Epsilon for $48 and wait. If the
merger happens at $50 per share or higher, the fund makes a profit of at least $2 per
share. There is, of course, the risk that the deal will not go through. If the merger is
blocked by say, the U.S. Justice Department, the hedge fund may take a loss if the
target company’s share price drops back to $42 per share.
 Share-for-share exchange. Consider a share-for-share exchange in which
Company Gamma is willing to exchange one of its shares for four of Company
Epsilon’s shares. What would happen to the price of Company Epsilon? Well,
assume that Company Epsilon’s shares were at 15% of the price of Company
Gamma, say $15 and $100, respectively. Post-announcement, Company Epsilon’s
share price might rise to what a 4:1 exchange would mean. In this case, prior to the
announcement, four of Company Epsilon’s shares would have been $60 per share.
Post-announcement, the notional value of each share of Company Epsilon would be
$25 per share (4 shares of Epsilon would be $100), a gain of 67%. A merger
arbitrage hedge fund would buy a certain amount of Company Epsilon’s stock and
simultaneously short a quarter as much of Company Gamma’s stock. If things go as
planned, the deal generates handsome profits.
Convertible Arbitrage
Convertible bonds are bonds that can be converted into the
equity of the bond issuer at specified times and prices in the
future. The price of the convertible bond depends upon:
 The price of the underlying equity.
 The volatility of the equity.
 Interest rates.
 Default probability.
Hedge fund managers involved in convertible arbitrage typically have complex models for
valuing convertible bonds. Many convertible bonds trade at undervalued prices compared to
their presumed fair market value. Some hedge fund managers with this strategy will buy the
convertible bonds and hedge their risks by shorting the underlying stock.
19
Fixed Income Arbitrage

A common hedge fund strategy related to fixed-income (bonds) is fixed-income arbitrage.
Underneath the fixed-income arbitrage umbrella are the details of each strategy, including
relative value, market neutral, and directional strategies.
 Relative value strategy. Hedge fund managers employing a relative value strategy
buy bonds where the zero-coupon yield curve indicates the bonds may be
undervalued by the market, and sell bonds along the same yield curve that it thinks
are overvalued.
 Market-neutral strategy. Hedge fund managers involved in market-
neutral strategies are using the same general tools as managers
using the relative value strategy, with the difference being that the
fund has no exposure to interest rate movements.
 Directional strategy. Some fixed-income hedge fund managers follow
directional strategies, where managers take positions based upon
expectations that certain interest rate spreads, or interest rates
themselves, will move in a direction favorable to their investment. It is
common for directional strategy funds to use leverage and must post
collateral with their prime brokers. This strategy generally has more short-term risk
than long-term risk because interest rate movements on orders of magnitude may be
relatively predictable, but in the short-term markets often move unpredictably.
Emerging Markets
Another common hedge fund strategy is to invest in emerging markets (sometimes referred
to as developing countries). Hedge funds investing in emerging markets may make equity,
debt, or some other type of investment.
 Equities. When managers make equity investments, managers invest in securities
trading on the local exchange, or through American Depository Receipts (ADRs). In
the case of ADRs, the certificates are backed by shares of a foreign company issued
in the U.S. The ADRs trade on U.S. exchanges. Why would hedge fund managers
invest in ADRs as opposed to owning the stock in its local currency? There are two
main reasons. First, ADRs may have better liquidity, and second, ADRs may have
lower transactions costs than the underlying foreign shares. Although snapped up
quickly, sometimes there are price discrepancies between ADRs and the underlying
shares that arbitragers may exploit.
 Debt. Typically, when managers invest in emerging
market debt, they are investing in Eurobonds or local
currency bonds.
o Eurobonds are bonds issued by the country
and denominated in a hard currency such as
the U.S. dollar or the euro.
o Local currency bonds are bonds
denominated in the local currency. Generally, local currency bonds are
thought to be riskier than Eurobonds because countries can print money (the
bonds are in their own currency) to pay off the bonds. In recent years, there
have been several incidents in emerging market debt, including defaults by
Argentina, Russia, Brazil, and Venezuela, to name a few.
20
Global Macro
Global macro strategies are perhaps the most flexible of investment strategies. Hedge fund
managers involved in global macro trade based upon expected global macroeconomic
trends. Essentially, global macro managers attempt to spot situations where markets have
moved “too far away” from equilibrium. After finding such situations, managers invest funds
in the direction of the markets towards equilibrium. Many global macro funds make
investment decisions based upon exchange rates and interest rates, among other factors.
Global macro funds may be further sub-divided into systematic (computer-driven algorithms)
or classic discretionary investing. Within these broad classifications are further sub-divisions,
such as funds that focus on:
 Types of trades, such as directional versus relative value.
 Geographic focus, such as emerging markets or developed countries.
 Asset class specialization, such as commodities, currencies, or volatility.
Examples. One potential macro strategy could be for the U.S. dollar to depreciate because
of the large balance of payments trade deficit. Perhaps the most famous global macro hedge
fund example is George Soros’s Quantum Fund. Mr. Soros bet heavily in 1992 that the
British pound would depreciate because of policy moves by the Bank of England and the
British government. His move would later be called “the man who broke the Bank of
England.”
Global macro funds possess many risks. Of the risks, and perhaps the most transparent, is
that managers do not really know where or when the equilibrium will be restored. Global
markets can be in disequilibrium for long periods of time.
Managed Futures
Hedge funds that employ a managed futures strategy are attempting to predict the future
movements in commodity prices.
When making investment decisions on the future of commodity prices, managers of

managed futures funds may use, among other techniques:
 Technical analysis. When managers employ technical analysis techniques, they
use historical price performance and other external forces to predict future price
movements.
o Technical analysis typically comprises back-testing, out-of-sample testing,
and other data mining techniques. These advanced modeling techniques are
different from the rules of fundamental analysis.
o Some data mining professionals will point out that out of the many thousands
of possible trading techniques, a few will perform well on historical data even
though there is no guarantee that they will perform well in the future.
Technical analysts are well aware of this critique.
 Fundamental analysis. When managers employ fundamental analysis techniques,
they are attempting to derive a fair value for the commodity based upon so-called
fundamental factors. Fundamental factors might include:
o Market conditions in which the fund is investing.
o The economy.
o Weather conditions, including projected weather conditions.
o Supply and demand forces.
o Cross-competition from other commodities
21
Describe characteristics of mutual fund and hedge fund

performance and explain the effect of measurement biases on
performance measurement.
Mutual Funds
Suppose you are a potential mutual fund investor. In addition to potentially investing in a
mutual fund, you can also invest in hedge funds, index funds, individual stocks,
commodities, and a host of other investment options. When considering investing in a
mutual fund, what questions might you ask? Some relevant questions might be:
 Will an investment in an actively managed mutual fund outperform the market (i.e.
should an investor pay a professional investor for their expertise)?
 If an investment in an actively managed fund outperforms the market in one year, will
it continue to outperform the market in subsequent years?
The answer to both questions, according to research begun in the 1960s by finance
professor Michael Jensen, is no6. Actively managed mutual funds generally do not beat the
market after one considers expenses associated with ownership of the funds.
The first question was answered simply with historical return data. Mr. Jensen answered the
second question by calculating the probability that a mutual fund that has beaten the market
for one or more years will do so again the following year (testing for persistence). He found
that only 50% of mutual funds that beat the market in one year accomplish the same feat in
the following year. Mutual funds that beat the market two years in a row also had a roughly
50% probability of beating the market in the following year. Similar results were obtained for
mutual funds that had beaten the market for three, four, five, and six years. While there may
be some mutual funds that can consistently beat the market, Jensen’s research (which has
been confirmed by other researchers many times over in recent years) indicates that the
chance of an actively managed fund consistently beating the market is less than 50%. There
is, of course, considerable debate on this topic.
One of the consequences of the research against putting money with an active manager has
been more investors placing money with index funds and other passively managed funds.
Index funds usually impose lower fees and may, on average, produce better returns, partially
because of the fees imposed by active managers.
Advertising of mutual fund returns. Jensen’s research may seem to contradict impressive
returns advertised by many mutual funds. The returns advertised by mutual funds are
probably accurate but may or may not hide important information. Usually, mutual funds offer
multiple funds to potential investors. Jensen’s research would suggest that a fund has a 50%
probability of beating the market in one year and that the probability that the specific fund will
beat the market every year for four years is 6.25% (( ) = .0625). If a company has 16
different funds, there is a high chance that one of its funds will have beaten the market every
year for the past four years. The mutual fund company may choose to advertise that fund as
opposed to the others.
6
See M. C. Jensen, “Risk, the pricing of capital assets, and the evaluation of investment portfolios,”
Journal of Business, 42 (April 1969): 167–247.
22
Hedge Funds
Measuring and comparing the returns of hedge funds is more difficult because of different
reporting requirements. As of today (and likely forever), there is no database with all return
information from inception to death. Some hedge funds do not report their results. It would
be pure speculation – although consistent with behavioral theory – that funds that incur
losses are less than excited about reporting to information accumulating databases. Hedge
funds that close also do not report their returns. This speculated tendency would result in an
upward bias in average reported return.
One possible source to compare hedge fund returns is the Credit Suisse Hedge Fund Index,
which is an asset-weighted index of hedge fund returns net of fees. Although it has non-
reporting bias, the database is an often-used source for hedge fund returns. The following
table compares the hedge funds returns with the S&P 500 (with dividends reinvested).
Although hedge funds performed very well before 2008, as did the S&P 500, in the same
year when the S&P 500 lost 37%, the Credit Suisse Hedge Fund Index reports that hedge
funds lost about 16%, on average. As one might expect, when the S&P 500 performed
poorly, the Hedge Fund Index performed quite well. The opposite story is true from 2009 to
2013, over which the S&P 500 beat the return of the average hedge fund every year.
Performance of Hedge funds7
Measurement Bias
Hedge funds may have a “winning streak” bias. Although not average, it is not at all
uncommon to see hedge funds report good returns for a few years and then to have some
poor performing years and the poor performing years lead to fund closure. Some critics of
hedge funds sometimes portray hedge funds with the phrase:
“Hedge fund returns are like the returns from writing out-of-the-money options: the options
cost nothing, but occasionally they become very expensive.8”
Other hedge fund tracking databases have the same non-reporting bias. For instance, the
Tass hedge funds database only includes hedge funds that report voluntarily. Small hedge
funds and those with poor track records usually do not report their returns. Also, the reported
returns may not be accurate, with Tass usually backfilling with the fund’s prior returns. The
reporting bias makes for comparing hedge fund returns with other asset classes less than
desirable. Overall, suffice it to say that there is considerable debate about the returns of
hedge funds compared with other asset classes.
7
Hull John, C. (2018). Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken, New Jersey, page 94
8
Hull John, C. (2018). Risk Management and Financial Institutions, John Wiley & Sons, Inc.,
Hoboken, New Jersey, page 93
23

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P1.T3. Financial Markets & Products

Chapter 3. Fund Management

Bionic Turtle FRM Study Notes

Chapter 3. Fund Management

DIFFERENTIATE AMONG OPEN-END MUTUAL FUNDS, CLOSED-END MUTUAL FUNDS, AND

Chapter 3. Fund Management

 Identify and describe potential undesirable trading behaviors at mutual funds.

 Calculate the net asset value (NAV) of an open-end mutual fund.

 Describe various hedge fund strategies, including long/short equity, dedicated

Differentiate among open-end mutual funds, closed-end mutual

Open-End Mutual Funds

Open-End Mutual Funds

 Index or passively managed fund. An index or passively managed fund is

Total Net Assets of Worldwide Regulated Open-End Funds3

Closed-End Mutual Funds

Identify and describe potential undesirable trading behaviors at

Calculate the net asset value (NAV) of an open-ended mutual fund.

In an open-ended mutual fund, the investor is responsible for

Adjustments for capital gains and losses

Explain the key differences between hedge funds and mutual

Differences Between Hedge Funds and Mutual Funds

Calculate the return on a hedge fund investment and explain the

= 0.5 ∙ 20% + 0.5 ∙ (−10%) = 5%

= 2% + 0.2 ∙ (20% − 2%) = 5.6%

= 2% + 0.2 ∙ {−10% − 2%, 0} = 2.0%

Incentives of Hedge Fund Managers

An example of a hedge fund manager’s incentive. As an example of the incentive

In this example, the expected return on the investment is -12%.

= 0.4 ∙ 60% + 0.6 ∙ (−60%) = −12%

An Example of a High-Risk Investment with a "2 + 20" Fee Structure

An Example of a High-Risk Investment with a "2 + 20" Fee Structure

Describe various hedge fund strategies, including long/short

Referring to a fund as long/short captures the broad picture.

Mergers arbitrage can be divided into two main types of deals:

Fixed Income Arbitrage

When making investment decisions on the future of commodity prices, managers of

Describe characteristics of mutual fund and hedge fund

Performance of Hedge funds7

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