bkmsol-ch26-9e corrected 8.9.10.docVIP

CHAPTER 26: HEDGE FUNDS PROBLEM SETS 1. No, a market-neutral hedge fund would not be a good candidate for an investor’s entire retirement portfolio because such a fund is not a diversified portfolio. The term ‘market-neutral’ refers to a portfolio position with respect to a specified market inefficiency. However, there could be a role for a market-neutral hedge fund in the investor’s overall portfolio; the market-neutral hedge fund can be thought of as an approach for the investor to add alpha to a more passive investment position such as an index mutual fund. 2. 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. 3. 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. 4. The problem of survivorship bias is that only the returns for survivors will be reported and the index return will be biased upwar