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LO 72.5: Explain how due diligence can be performed on a funds operational environment.
Investors should focus on several key areas when performing operational due diligence on a fund. The focus areas are internal control assessment, documents and disclosure, and service provider evaluation.
Internal Control Assessment
A starting point in due diligence is examining the qualifications and attitudes of the personnel. For instance, does the CEO believe in controls and compliance with the rules? An analyst must also assess whether the internal control staff have sufficient technical and work experience to perform their compliance duties properly. Have they been properly trained and do they continue to expand their skills in compliance? Some assurance may be required regarding whether the back and middle office managers are sufficiently experienced in performing supervisory duties. Finally, background checks on critical internal control staff members might be required.
Examining the funds policies and procedures may also be useful. Related documents may cover areas such as trading, derivatives usage, and transaction processing. One drawback is that these documents tend to be general and only demonstrate the intention to have a strong control environment. In other words, merely reading the documents provides little assurance that the policies and procedures are actually being followed or are effective. It is
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usually a good sign if a fund has been proactive and obtained an audit report and opinion on the effectiveness of its controls. If this report is available, it should be reviewed.
The due diligence process should include an examination of the in-house or outsourced compliance system that is in place. Examples of specific items to consider include the code of ethics (if one exists) and any restrictions on employee trading and related-party transactions.
There should be an investigation into how the funds deal with counterparty risk arising from OTC derivatives and other counterparties. Is such risk mitigated by dealing with more than one counterparty? Are the counterparties monitored for risk on a daily basis?
Finally, there should be an assessment as to the effectiveness of corporate governance. Is it pervasive throughout the organization? Are examples of internal control breaches followed up with appropriate actions to remedy and prevent future recurrence?
Documents and Disclosure
As part of the due diligence process, investors must confirm with the funds legal counsel its involvement in preparing the original version of the fund documents as well as any subsequent revisions. The investor should also confirm if the law firm remains as the funds legal counsel. A physical check of the documents should be made to look for any changes made after the date indicated on the documents.
The investor should corroborate the terms of the offering memorandum by examining other documents such as the Form ADV, subscription agreement, and investment management agreement. Consistency is important here. Terms relating to fees, redemption rights, liquidity, and lockups should be examined closely and clarified with the manager if required.
Conflicts of interest that are disclosed in the offering memorandum should be scrutinized carefully. Lack of clarity in the disclosure may be a red flag and warrant further discussion with the manager and/or require independent information.
Similarly, lack of clarity or sufficiency in the disclosure of risks may warrant further investigation. The discussion of very general or irrelevant risk factors may be cause for concern.
The focus of any due diligence should be on the manager. As a starting point, the potential investor should determine the extent of the managers authority. Are the provisions very broad (potentially more risky) or quite specific? Is the manager subject to limitations on the amount of leverage employed or on the percentage of the fund invested in specific securities, sectors, or industries? Can the manager be indemnified for his actions outside of fraud, gross negligence, or malicious intent? Additionally, there should be a consideration of the managers reporting duties to investors (e.g., audited financial statements, disclosure of the tax treatment of the funds income and transactions).
In analyzing the financial statements, the investor should begin by ensuring the audit opinion is unqualified (i.e., the auditor believes the financial statements contain no material misstatements). The balance sheet and income statement should be examined for
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consistency with the funds investment strategy (e.g., a high leverage fund should have high interest expense on the income statement and high liabilities on the balance sheet). Any inconsistencies should be discussed with the manager on a timely basis. In addition, the footnotes (which are also audited) should be examined carefully since they provide more detailed information on key items (e.g., contingent liabilities, related-party transactions) than the corresponding financial statements.
Fees paid to the manager by the fund should be scrutinized and recalculated. They should be corroborated with the offering memorandum. Specifically, there should be a check of any incentive fees paid in loss years.
Finally, there should be a check for the level of net contributions to the fund by the general partner. .Any fund withdrawals should be questioned.
Service Provider Evaluation
Third-party service providers may be hired by a fund for trade execution, information technology, valuation, verification, and asset safeguarding purposes.
A starting point for assessing the actual service providers is to examine the internal control letters issued by its auditors and its audited financial statements. Further due diligence could be performed through in-person discussions regarding the service providers role.
Bu s in e s s M o d e l a n d Fr a u d Ris k

LO 72.4: Describe criteria that can be evaluated in assessing a funds risk management process.
A proper risk management process should contain an assessment of the following areas: risk, security valuation, portfolio leverage and liquidity, tail risk exposure, risk reports, and consistency of the fund terms with the investment strategy.
Risk
Assess the applicable systematic risk factors (i.e., regular market risks common to most or all funds) and unsystematic risk factors (i.e., risks specific to the manager, fund, or strategy).
Determine whether written policies and procedures exist regarding measuring and
Determine whether a risk committee exists that would receive such measurements. If so,
monitoring risk.
how often are they reported?
Evaluate the extent of the risk management culture among the various types of
employees. For example, how actively involved are employees with managing and mitigating the firms risks on a day-to-day basis?
Assess the information technology resources used to quantify the risks. For example,
are they reliable and do they measure items consistently between traders and portfolio managers? Identify the existence and structure of any risk models. What are their inputs and assumptions? Have the models been tested and are they robust?

Security Valuation
Identify the proportion of fund assets that are objectively valued through reliable market prices versus those that are more subjectively valued by the broker or through simulation.
Examine the independence of valuations. Is valuation performed by the fund
administrator (generally more independent) or by the fund manager (generally less independent)?
Determine if prices may be overridden for valuation purposes. If so, by whom? Is there
documentation or an approval process?
Portfolio Leverage and Liquidity
Assess the sources of leverage as well as the current and historical levels of leverage. Calculate the current level of liquidity and observe how it has changed over time. The
current level is especially relevant because of the impact on portfolio investment capacity and whether it can take on more investment capital.
Within a stated investment strategy, excessive leverage and/or illiquidity could generate
actual returns that are significantly different than expected (i.e., no longer comparing apples to apples), thereby requiring an adjustment in expected returns.
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Exposure to Tail Risk

.Analyze information about the fund to conclude whether the funds return distribution possesses skewness or kurtosis.
Discuss the possibility of tail risk with the manager and determine whether the manager
has sufficiently mitigated the risk or whether further action is required by the investor.
Risk Reports
Review risk reports prior to investing in the fund. Investors should receive these risk
reports on a regular basis (e.g., monthly, quarterly, annually) whether they are prepared in-house or by a third party.
Analyze key risk metrics and compare them to other similar funds for benchmarking
purposes and for determining if any unusual risks exist in the fund.
Consistency of the Fund Terms with the Investment Strategy
Examine the general fee structure of the fund and determine whether it is consistent with
similar funds. Identify the existence of any additional fees after a specific threshold (e.g., high-water mark, hurdle rate).
Evaluate whether high fees are being paid to managers in search of market alpha (fair) as

opposed to beta (unfair). Identify the existence of any limitations or blackout periods on redemptions.
O pe r a t io n a l D u e D il ig e n c e

LO 72.3: Identify themes and questions investors can consider when evaluating a manager.
Manager evaluation is not a task that should be taken lightly by potential investors. This process can be broken down into four areas including strategy, ownership, track record, and investment management.
Strategy
General questions regarding a managers strategy may include: Does the manager follow a particular investment style (e.g., growth, value)? Are there any current trends in the fund or specializations in specific securities,
industries, or sectors?
How has the fund changed its investment style or rebalanced its holdings over the past
year? What changes are contemplated in light of anticipated market conditions?
What is the extent of turnover and liquidity in the fund? What market signals are used to
determine whether to exit or enter a position?
What mechanisms are in place to limit any potential losses in the fund? To what extent is quantitative analysis and modeling utilized in the investment process?
Have any models been developed or tested to date?
Are short sales used to generate excess profits or to hedge? How successful or detrimental
Are derivatives used in the portfolio? If so, are they used for hedging or speculative
How does the trade execution process work? Does a central trading desk exist for
have they been so far?
purposes?
maximum efficiency?
overall investment strategy?
What is the extent of any investment in private company securities and their role in the
What is the tradeoff between maximizing current returns versus long-term fund growth? Has the fund ever been closed or provided investors with a return of capital?
Ownership
Ownership interests often help align the interests of the investment team and the investors. They can be useful in attracting and maintaining quality staff, thereby enhancing and/or continuing to generate strong investment returns for investors.
Therefore, potential investors should inquire as to whether any members of the investment team (e.g., traders, portfolio managers, research analysts) have ownership interests in the firm.
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Track Record
Specific questions about the managers and funds track records may include: How does the past performance of the manager and/or fund compare to its peers and/or
funds that follow the same or similar investment philosophy?
Has past performance been audited or verified by a third party?
Is there sufficient performance history to perform trend and/or attribution analysis? How did the manager or fund perform during market downturns?
What were the investment returns relative to the size of the investment assets? Are most or all of the staff on the investment team that generated those past results still
employed by the firm?
Investment Management
Inquiries during manager interviews may include: What is/was the managers investment strategy for generating excess returns? How did the manager cope with tough market periods? Reference checks on managers could include the following individuals:
Former employers: Was the manager a leader or follower? Proactive or reactive? A team player or individualist?
Current and former colleagues, clients, and other independent parties: Ensure
consistency but if there are mixed reviews, follow up for explanations and/or obtain clarification from the manager.
Current and former investors: What good and bad investment experiences did they have
with the manager?
Background checks on managers may include the following questions/activities: Obtaining comprehensive background check reports on the manager. Review the Form ADV filed by the manager with the SEC and state securities
authorities. It contains general information about the business as well as more detailed information such as fees, services provided, conflicts of interest, and background of key personnel.
Has the manager consistently demonstrated herself to be a person of integrity? This
could be verified by examining public databases and the SEC website to look for any past or current instances of litigation or criminal behavior.
Has the manager demonstrated strong personal financial responsibility? This could be
verified by examining personal credit reports and bankruptcy reports.
Are the managers stated representations accurate? This could be verified by inquiring
with auditors and brokers who are currently working with the manager or have worked with the manager in the past.
What is the extent of the managers involvement in any related party transactions?
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Ris k M a n a g e m e n t Ev a l u a t io n

LO 72.2: Explain elements of the due diligence process used to assess investment managers.
Prior to investing, an investor performs due diligence on a potential investment manager, which involves assessing the manager, the fund, and the investment strategy. Information such as the investment background, managers reputation (e.g., education, employers), and past performance have always been key considerations but are insufficient on their own.
An additional element of due diligence involves assessing the investment process and risk controls. The starting point is a review of the funds prospectus or offering memorandum. Additionally, an attribution analysis could be performed to determine how the returns were generated. Were they generated through the skill and control of the manager, luck, and/or factors beyond the managers control? In addition, was the amount of return in line with the amount of risk taken?
Another related element is assessing the funds operations and business model. In general, are there internal controls and policies in place to preserve the investors funds? Specifically, are the controls in place sufficiently robust to detect and prevent fraudulent activities or are limits imposed on managers to seek higher level approval for transactions exceeding a certain dollar amount or frequency? Is there appropriate segregation of duties between the front office and the back office? What is the process and frequency of asset valuations? What is the fee structure and are there any additional fees after a specific threshold? Are there any limitations or blackout periods on redemptions?
In the end, investors should assess potential managers and their investment strategies with an objective and unbiased mind. They should not get caught up with a managers past successes.
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M a n a g e r Ev a l u a t io n

LO 72.1: Identify reasons for the failures of funds in the past. * 1
Investors should be familiar with the reasons past funds have failed to ensure they can avoid investing in a failing fund. Following is a concise list of reasons past funds have failed. 1. Poor investment decisions. Could be a series of decisions (domino effect) or a very
calculated risk on a specific investment that backfired.
2. Fraud. Fraud could occur in several forms including accounting (e.g., misstating asset book values or misstating income), valuation (e.g., misstating asset market values), and theft of funds.
3. Extreme events. Events occurring that would otherwise occur with very low probability
or were unexpected (e.g., market crashes).
4. Excess leverage. Related to making poor investment decisions. Leverage goes both ways.
That is, it magnifies gains but also magnifies losses.
3. Lack of liquidity. Too many capital withdrawals and redemptions to honor at once,
thereby creating a squeeze on cash flow and an inability to meet all capital withdrawals and redemptions.
6. Poor controls. Closely related to fraud. Lack of supervision could result in excessive
risks being taken that lead to losses large enough to bankrupt the fund.
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7.
Insufficient questioning. Often in a committee-style decision-making process, there may be a dominant member who sways the decision and/or members who are afraid to voice any valid concerns over information they have discovered that would question the merits of the investment manager and/or investment. Ideally, all due diligence team members should be encouraged to play the role of devils advocate when appropriate and raise reasonable concerns as early as possible, especially before they reach the committee stage.
8.
Insufficient attention to returns. Investment funds attempting to reduce operational risk sometimes overcompensate by implementing excessive controls and may end up bearing too many expenses and not generating enough returns. Ideally, there is a healthy balance between generating strong returns while taking on a reasonable level of risk.
D u e D il ig e n c e El e m e n t s

LO 71.10: Explain the impact of institutional investors on the hedge fund industry and assess reasons for the growing concentration of assets under management (AUM) in the industry.
As mentioned earlier, beginning in 2000, institutional investor funds flowed into hedge funds, and assets under management in the hedge fund industry grew from $ 197 billion at 1999 year-end to $1.39 trillion by 2007 year-end. Institutional investors were rewarded for allocating capital to a much higher fee environment. Three hedge fund performance databases, DJCSI, HFRI, and HFRFOFI, respectively, reported cumulative performance of 72.64%, 69.82%, and 38.18% from the 2002 to 2010 time period, compared to the S&P 300 index return of 13.3%. The S&P 500 index had a 16% standard deviation during that period, versus annualized standard deviations of return of 5.84%, 6.47%, and 5.51%, for the respective hedge fund indices.
With the increase of institutional investment came greater demands on hedge fund management for operational integrity and governance. Some institutional investors were seeking absolute performance, while others were seeking alternative sources of return beyond equities. There is some concern that there is no identifiable alpha associated with hedge fund investing, so it is increasingly important that hedge fund managers differentiate themselves from their peers.
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Ke y Co n c e pt s
LO 71.1 Hedge funds are private investments and have very little financial regulation. They tend to be highly leveraged, and managers make large bets. On the other hand, mutual funds are regulated and more structured.
LO 71.2 There are some hedge funds that do not participate in commercial databases, which impacts aggregate hedge fund performance. Thus, there is selection bias contained in hedge fund databases.
LO 71.3 There have been major events affecting the hedge fund industry, including large losses following a change in Fed policy in 1994, the LTCM collapse in 1998, and the dot-com collapse in 2001.
LO 71.4 >From 1999 to 2007, investors in hedge funds shifted from exclusively private wealth to institutions, including foundations, endowments, pension funds, and insurance companies.
LO 71.5 Alpha is the return in excess of the compensation for risk. Beta is a measure of the systematic risk of the security or portfolio relative to the market as a whole. Firms may independently manage alpha and beta. This is known as separating alpha and beta. Managers can use investment tools to pursue alpha while sustaining a target beta for the portfolio.
LO 71.6 Managed futures funds focus on investments in bond, equity, commodity futures, and currency markets around the world. The payoff function of this strategy is similar to a lookback straddle.
Global macro managers make large bets on directional movements in interest rates, exchange rates, commodities, and stock indices, and do better during extreme moves in the currency markets.
Merger arbitrage funds bet on spreads related to proposed merger and acquisition transactions, and perform poorly during major market declines.
Distressed hedge funds invest across the capital structure of firms that are under financial or operational distress, or are in the middle of bankruptcy. The strategy tends to have a
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long-bias. These hedge fund managers try to profit from an issuers ability to improve its operation, or come out of a bankruptcy successfully.
Fixed income arbitrage funds try to obtain profits by exploiting inefficiencies and price anomalies between related fixed income securities. Their performance is correlated to changes in the convertible bond default spread.
Convertible arbitrage funds attempt to profit from the purchase of convertible securities and the shorting of corresponding stock.
Long/short equity funds take both long and short positions in the equity markets, diversifying or hedging across sectors, regions, or market capitalizations, and have directional exposure to the overall market and also have exposure to long small-cap/short large-cap positions.
Dedicated short bias funds tend to take net short positions in equities, and their returns are negatively correlated with equities.
Emerging market funds invest in currencies, debt, equities, and other instruments in countries with emerging or developing markets.
Equity market neutral funds attempt to achieve zero beta(s) against a broad set of equity indices.
LO 71.7 The top 50 hedge funds demonstrated statistically significant alpha relative to the DJCSI and HFRI hedge fund indices. The strategy of buying large hedge funds appears to deliver superior performance compared to just investing in hedge fund indices. Hedge fund managers are still delivering alpha relative to peers, and also have low exposure to the U.S. equity market.
LO 71.8 Diversification among hedge fund strategies may not always be effective due to the convergence of risk during times of extreme market stress. There is significant credit-driven tail risk in a hedge fund portfolio. The use of managed futures may be a partial solutionit has been a strategy with a convex performance profile relative to other hedge fund strategies. Hedge fund investors need to consider portfolio risks associated with dramatic market events.
LO 71.9 In the hedge fund industry, risk sharing asymmetry between the principal (investor) and the agent (fund manager) is a concern due to variable compensation schemes.
LO 71.10 Institutional investors flocked to hedge funds beginning in 2000. With the increase of institutional investment came greater demands on hedge fund management for operational integrity and governance.
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Co n c e pt Ch e c k e r s
1.
2.
3.
4.
3.
What critical shift occurred in the hedge fund industry following the collapse of Long-Term Capital Management (LTCM) in 1998 and the dot-com bubble burst in 2001? A. There was a significant drop in assets under management in the hedge fund
B. There was a large influx of institutional investors investing in hedge funds. C. Reporting within the hedge fund industry became more regulated than mutual
industry.
funds.
D. There was a significant increase in hedge fund failures.
Which of the following hedge fund strategies would be characterized as an asset allocation strategy that performs best during extreme moves in the currency markets? A. Global macro. B. Risk arbitrage. C. Dedicated short bias. D. Long/short equity.
Comparing hedge fund performance during the time period 2002-2010 to earlier time periods, how would monthly alpha compare, if looking at large hedge funds? A. Alpha was higher in the 2002-2010 time period. B. Alpha remained constant over both time periods. C. A foresight-assisted portfolio did not have a statistically significant alpha
during the 2002-2010 time period.
D. There was a decline in alpha in the 2002-2010 time period.
Jamie Chen, FRM, is considering investing a client into distressed hedge funds. Which of the following investments would serve as the best proxy for the types of returns to expect? A. Convertible bonds. B. Small-cap equities. C. Managed futures. D. High-yield bonds.
What would be an ideal approach for a hedge fund investor who is concerned about the problem of risk sharing asymmetry between principals and agents within the hedge fund industry? A. Focus on investing in funds for which the fund managers have a good portion of
their own wealth invested.
B. Focus on diversifying among the various niche hedge fund strategies. C. Focus on funds with improved operational efficiency and transparent corporate
governance.
D. Focus on large funds from the foresight-assisted group.
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Co n c e pt Ch e c k e r An s w e r s
1. B During the time period following the dot-com collapse, hedge funds outperformed the
S&P 500 with a lower standard deviation, which attracted institutional investment.
2. A A global macro fund does better if there are extreme moves in the currency markets.
Along with managed futures, global macro is an asset allocation strategy. Managers take opportunistic bets in different markets. The strategy has a low correlation to equities.
3. D Comparing the two different time periods, there was a decline in alpha due to more
competition in the hedge fund industry.
4. D Distressed hedge funds have long exposure to credit risk of corporations with low credit
ratings. Publicly traded high-yield bonds are a good proxy for the returns to expect.
5. A The incentive fee structure within the hedge fund industry has not really changed over the years, and there is incentive for managers to take undue risks in order to earn fees. Thus, there should be a focus on investing in funds for which the fund managers have a good portion of their own wealth invested.
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The following is a review of the Risk Management and Investment Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Pe r f o r m i n g D u e D i l i g e n c e o n Spe c i f i c M a n a g e r s a n d Fu n d s
Ex a m Fo c u s
This topic emphasizes the reasons investors should perform due diligence on potential investments. It provides a thorough list of items to consider in the due diligence process. For the exam, understand in detail the steps involved in evaluating a manager, a funds risk management process, and a funds operational environment.
Topic 72
Pa s t Fu n d Fa il u r e s

LO 71.9: Describe the problem of risk sharing asymmetry between principals and agents in the hedge fund industry.
In the hedge fund industry, risk sharing asymmetry between the principal (investor) and the agent (fund manager) is a concern due to variable compensation schemes.
The problem occurs when the incentive fee that a hedge fund manager is entitled to, typically 1520% of new profits [profits above a high water mark (HWM)], encourages a fund manager to take outsized risks. This tends to increase the future loss-carried-forward if
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and when these bets fail. If the fund fails, the same fund manager can start up a new hedge fund.
However, there is an opportunity cost involved in cases where a hedge fund manager closes a fund. It is costly in terms of harming the track record of the manager and affects reputation risk of both the manager and the fund company. All things considered, this cost does not totally mitigate the basic principal/agent conflict.
Investors may be best served to invest in funds for which the fund managers invest a good portion of their own wealth. As much as this issue has been discussed, the basic structure of how fund managers are compensated has not changed.
Im pa c t o f In s t it u t io n a l In v e s t o r s

LO 71.8: Describe market events that resulted in a convergence of risk factors for different hedge fund strategies, and explain the impact of such a convergence on portfolio diversification strategies.
Theoretically, diversification among hedge fund strategies should protect investors, but there are certain events that affect all, or mostly all, strategies, as they all undergo stress at the same time. Portfolio diversification implodes, and seemingly diverse hedge fund portfolios converge in terms of risk factors during times of stress.
The first recorded major market event for hedge funds was in March and April of 1994 when unexpected changes in interest rate policy were set by the Federal Reserve. This caused two months of losses by seven of the ten style-specific sub-indices in the DJCS family. Exceptions were short sellers and managed futures funds. Merger arbitrage funds earned a positive return in March, while equity market neutral funds had a positive return in April.
Another major event was in August 1998 right before the collapse of LTCM. Eight of the ten niche DJCS style sub-indices had large losses. Short sellers and managed futures funds avoided losses. The losses occurred primarily due to market-wide liquidation of risky assets and the high amount of leverage on LTCMs balance sheet.
With hedge fund investing, leverage has a magnifying effect on gains and losses, and risk is on both sides of the balance sheet. There were events prior to the 20072009 financial crisis that illustrated how much a market-wide funding crisis can significantly impair leveraged positions. In August 2007, for the first time, all nine specialist style sub-indices lost money. The only positive return was from short sellers. During the peak of the financial crisis from July to October 2008, July to September brought losses for all hedge fund styles (excluding short sellers). When leveraged positions are forced to liquidate, losses can be high.
The point is that when there is a market-wide funding crisis, it is difficult to mitigate risk by simply spreading capital among different hedge fund strategies. There is significant credit-driven tail risk in a hedge fund portfolio. The use of managed futures may be a partial solutionit has been a strategy with a convex performance profile relative to other hedge fund strategies. Hedge fund investors need to consider portfolio risks associated with dramatic market events.
Ris k Sh a r in g As y m m e t r y

LO 71.7: Describe the historical portfolio construction and performance trend of hedge funds compared to equity indices.
Twenty-seven large hedge funds were identified in 2000, and research has been done to determine if these hedge funds are truly a separate asset class, not correlated to equity or bond indices. Hedge fund returns were regressed against an 8-factor model used to analyze hedge fund performance. Findings were that hedge fund portfolios had no significant exposure to stocks and bonds. As an equally weighted portfolio, this portfolio of 27 top performing hedge funds had a large alpha of 1.48% per month. There was a persistent exposure to emerging markets, but other factor betas showed a lot of variability. Also, alpha declined over time, and there was not a persistent directional exposure to the U.S. equity market. Measurement bias may have affected these results somewhat.
Alternatively, a strategy of investing in a portfolio of the top 50 large hedge funds was tested using data from 2002 to 2010. Two test portfolios were constructed: The first test portfolio attempted to mimic performance of a strategy of investing in the top funds in equal dollar amounts, and rebalancing at the end of each calendar year. The funds were selected based on the assets under management at year-end 2001.
A similar portfolio was constructed using top funds based on year-end 2010, rather than
2001.
For the first portfolio, the intent was to give a lower and upper bound of performance which investors could achieve, by just following a strategy of investing equally in the top 50 large hedge funds, and rebalancing yearly. The second portfolio was foresight assisted.
In evaluating performance characteristics, the first portfolio did not have a significant alpha, while the foresight-assisted portfolio had a monthly alpha of 0.53%, and was statistically significant at the 1% level. Compared to hedge fund returns prior to 2002, the decline in alpha is consistent with the thinking that there is more competition in the hedge fund industry. It should, however, be noted that there is no significant negative alpha.
Looking at the top 50 hedge funds versus all hedge funds, the top 50 portfolios (both versions) demonstrated statistically significant alpha relative to the DJCSI and HFRI hedge fund indices. The strategy of buying large hedge funds appears to deliver superior performance compared to just investing in hedge fund indices.
During the 2002 to 2010 time period, the top 50 hedge fund portfolios (with the exception of the foresight-assisted portfolio), and the two broad hedge fund indices, DJCSI and HFRI, all outperformed the equity market, as measured by the S&P 500 index. In sum, analysis of large hedge funds shows that managers are still delivering alpha return relative to peers, and also have low exposure to the U.S. equity market. These factors continue to attract institutional investors.
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C o n v e r g e n c e o f Ris k Fa c t o r s

LO 71.6: Compare and contrast the different hedge fund strategies, describe their return characteristics, and describe the inherent risks of each strategy.
Managed Futures and Global Macro
Managed futures funds focus on investments in bond, equity, commodity futures, and currency markets around the world. Systematic trading programs are used which rely on historical pricing data and market trends. A high degree of leverage is employed because futures contracts are used. With managed futures, there is no net long or net short bias.
Many managed futures funds are market timing funds, which switch between stocks and Treasuries. When both short and long positions are considered, the payoff function of this strategy is similar to a lookback straddle, which is a combination of a lookback call option and a lookback put option. The lookback call option gives the owner the right to purchase the underlying instrument at the lower price during the call options life, while the lookback put option gives the owner the right to sell the underlying instrument at the highest price during the put options life.
Global macro fund managers make large bets on directional movements in interest rates, exchange rates, commodities, and stock indices. They are dynamic asset allocators, betting on various risk factors over time.
Both managed futures and global macro funds have trendfollowing behavior (i.e., directional styles). Global macro funds do better during extreme moves in the currency markets. Both of these strategies are essentially asset allocation strategies, since the managers take opportunistic bets in different markets. They also both have a low return correlation to equities.
Merger/Risk Arbitrage and Distressed Securities
Merger (or risk) arbitrage strategies try to capture spreads in merger/acquisition transactions involving public companies, following public announcement of a transaction. The primary risk is deal risk, or the risk that the deal will fail to close.
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Examining merger arbitrage returns, the largest negative monthly returns in this strategy are after the S&P 500 index has had a large negative return. This equates to being long deal risk. The logic is that when the market has a large decline, mergers have a greater tendency to be called off.
Distressed hedge funds is another event-driven hedge fund style. This strategy invests across the capital structure of firms that are under financial or operational distress, or are in the middle of bankruptcy. The strategy tends to have a long bias. With this strategy, hedge fund managers try to profit from an issuers ability to improve its operation, or come out of a bankruptcy successfully.
A key feature of the strategy is long exposure to credit risk of corporations with low credit ratings. A good proxy for these types of returns is publicly traded high-yield bonds since the correlation between the DJCS Distress index and high-yield bonds is 0.55.
In sum, both of these event-driven strategies exhibit nonlinear return characteristics, since tail risk appears under extreme market conditions. With merger arbitrage, the tail risk is a large drop in equity investments. With distressed hedge funds, the tail risk is a big move in short-term rates. Unlike trend following strategies, event-driven funds are hurt by extreme market movements.
Fixed Income Arbitrage
Fixed income arbitrage funds attempt to obtain profits by exploiting inefficiencies and price anomalies between related fixed income securities. The fund managers try to limit volatility by hedging exposure to interest rate risk. An example of this strategy is leveraging long/short positions in fixed income securities that are relatedmathematically or economically.
The sectors traded under fixed income arbitrage include: Credit yield curve relative value trading of swaps, government securities, and futures. Volatility trading using options. Mortgage-backed securities arbitrage. A swap spread trade is a bet that the fixed side of the spread will stay higher than the floating side of the spread, and stay in a reasonable range according to historical trends. With yield-curve spread trades, the hope is that bond prices will deviate from the overall yield curve only in the short term, and will revert to normal spreads over time. Mortgage spread trades are bets on prepayment rates, while fixed income volatility trades are bets that the implied volatility of interest rate caps have a tendency to be higher than the realized volatility of, for example, a Eurodollar futures contract. Capital structure or credit arbitrage trades try to capitalize on mispricing among different types of securities (e.g., equity and debt).
Convertible Arbitrage
Convertible arbitrage funds attempt to profit from the purchase of convertible securities and the shorting of corresponding stock, taking advantage of a perceived pricing error made in the securitys conversion factor. The number of shares shorted is based on a delta neutral or
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market neutral ratio. The plan is for the combined position to be insensitive to underlying stock price fluctuations under normal market conditions.
The return to convertible arbitrage hedge funds comes from the liquidity premium paid by issuers of convertible bonds to hedge fund managers, for holding convertible bonds and managing the inherent risk by hedging the equity part of the bonds.
Long/Short Equity
Long/short equity funds take both long and short positions in the equity markets, diversifying or hedging across sectors, regions, or market capitalizations. Examples are shifts from value to growth, small- to mid-cap stocks, and net long to net short. Trades in equity futures and options can also take place.
Thirty to forty percent of hedge funds are long/short. Long/short managers are stock pickers with varying opinions and abilities, so performance tends to be very idiosyncratic. Underpriced or under-researched stocks are favored, as are small stocks, on the long side. On the short side, low liquidity makes small stocks and foreign stocks less attractive. Long/short equity funds have directional exposure to the overall market and also have exposure to long small-cap/short large-cap positions.
Dedicated Short Bias
Funds with a dedicated short bias tend to take net short positions in equities. Sometimes the short position strategy is implemented by selling forward. To manage risk, managers take offsetting long positions and stop-loss positions. The returns are negatively correlated with equities.
Emerging Markets
Emerging market funds invest in currencies, debt, equities, and other instruments in countries with emerging or developing markets. These markets are usually identified in terms of gross national product (GNP) per capita. China, India, Latin America, Southeast Asia, parts of Eastern Europe, and parts of Africa are examples of emerging markets. These funds have a long bias because it is more difficult to short securities in emerging markets.
Equity Market Neutral
When reviewing equity market neutral hedge fund strategies, research shows that there is not one common component (or risk factor) in their returns. Different funds utilize different trading strategies, but they all have a similar goal of trying to achieve zero beta(s) against a broad set of equity indices.
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H e d g e Fu n d Pe r f o r m a n c e