TUTORIAL WEEK 12

Portfolio Management
26.2
◦ How might the incentive fee of a hedge fund affect the manager’s propensity to take on high risk assets
in the portfolio?
◦ The incentive fee of a hedge fund is part of the hedge fund compensation structure; the incentive fee is
typically equal to 20% of the hedge fund’s profits beyond a particular benchmark rate of return.

◦ Therefore, the incentive fee resembles the payoff to a call option, which is more valuable when volatility
is higher.

◦ Consequently, the hedge fund portfolio manager is motivated to take on high-risk assets in the portfolio,
thereby increasing volatility and the value of the incentive fee.
26.3
◦ Why is it harder to assess the performance of a hedge fund portfolio manager than that of a typical
mutual fund manager?
◦ There are a number of factors that make it harder to assess the performance of a hedge fund portfolio
manager than a typical mutual fund manager. Some of these factors are
◦ Hedge funds tend to invest in more illiquid assets so that an apparent alpha may be in fact simply
compensation for illiquidity.
◦ Hedge funds’ valuation of less liquid assets is questionable.
◦ Survivorship bias and backfill bias result in hedge fund databases that report performance only for more
successful hedge funds.
◦ Hedge funds typically have unstable risk characteristics making performance evaluation that depends on
a consistent risk profile problematic.
◦ Tail events skew the distribution of hedge fund outcomes, making it difficult to obtain a representative
sample of returns over relatively short periods of time.
26.4
◦ Which of the following is most accurate in describing the problems pf survivorship bias and backfill bias
in the performance evaluation of hedge funds?
◦ A, both of them result in upwardly biased hedge fund index return.
◦ B, both of them result in downwardly biased hedge fund index return.
◦ C, Survivorship bias results in upwardly biased hedge fund index returns, but backfill bias results in
downwardly biased hedge fund index returns.
◦ The problem of survivorship bias is that only the returns for survivors will be reported and the index
return will be biased upwards. Backfill bias results when a new hedge fund is added to an index and the
fund’s historical performance is added to the index’s historical performance. The problem is that only
funds that survived will have their performance added to the index, resulting in upward bias in index
returns.
26.6
◦ With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than
that earned from an individual hedge fund because of:

◦ A. Both the extra layer of fees and the higher liquidity offered.
◦ B. No reason; funds of funds earn returns that are equal to those of individual hedge funds.
◦ C, The extra layer of fees only.
◦ Funds of funds are usually considered good choices for individual investors because they offer
diversification and usually more liquidity. One problem with funds of funds is that they usually have
lower returns. This is a result from both the additional layer of fees and cash drag (resulting from the
desire for liquidity).
26.9
◦ A hedge fund with $1 billion of assets charges a management fee of 2% and an incentive fee of 20% of
returns over a money market rate, which currently is 5%. Calculate total fees, both in dollars and as a
percent of assets under management, for portfolio returns of:
◦ −5%
◦ 0
◦ 5%
◦ 10%
Management fee = 0.02 × $1 billion = $20 million

  Portfolio Rate Incentive Fee Incentive Fee Total Fee Total Fee
of Return (%) (%) ($ million) ($ million) (%)

a. -5 0 0 20 2

b. 0 0 0 20 2

c. 5 0 0 20 2

d. 10 20 10 30 3
26.10
◦ A hedge fund with net asset value of $62 per share currently has a high water mark of $66. Is the value of
its incentive fee more or less than it would be if the high water mark were $67?
◦ The incentive fee is typically equal to 20 percent of the hedge fund’s profits beyond a particular
benchmark rate of return.
◦ However, if a fund has experienced losses in the past, then the fund may not be able to charge the
incentive fee unless the fund exceeds its previous high-water mark. The incentive fee is less valuable if
the high-water mark is $67, rather than $66.

◦ With a high-water mark of $67, the net asset value of the fund must reach $67 before the hedge fund can
assess the incentive fee.