B. illiquid assets.

C. a short time horizon.

2. Compared with purchasing commodities, long positions in commodity derivatives offer the
benefit of:
A. no storage costs.
B. convenience yield.
C. better correlation with spot prices.
3. Greenfield investments in infrastructure are described as investments in
assets:
A. that are operating profitably.
B. that have not yet been constructed.
C. related to environmental technology.

Video covering
LOS 60.f: Explain investment characteristics of hedge funds. this content is
available online.

Hedge funds generally:

Use leverage.
Take both long and short positions.
Use derivatives for speculation or hedging portfolio risk.
In addition to the structures for limited partnerships and types of fees paid to the general
partner we have covered, hedge funds typically have restrictions on limited partner
redemptions. A lockup period is the time after initial investment over which limited partners
either cannot request redemptions or incur signi icant fees for redemptions (a soft lockup). A
notice period (typically between 30 and 90 days) is the amount of time a fund has to ful ill a
redemption request made after the lockup period has passed.
Hedge fund managers often incur signi icant transactions costs when they redeem shares.
Redemption fees can offset these costs. Notice periods allow time for managers to reduce
positions in an orderly manner. Redemptions often increase when hedge fund performance is
poor over a period, and the costs of honoring redemptions may further decrease the value of the
remaining partnership interests. This is an additional source of risk for hedge fund investors.
A fund-of-funds is an investment company that invests in hedge funds. Fund-of-funds investing
can give investors diversi ication among hedge fund strategies, can provide expertise in
selecting individual hedge funds, and can provide smaller investors with access to hedge funds
in which they may not be able to invest directly.
Fund-of-funds managers charge an additional layer of fees beyond the fees charged by the
individual hedge funds in the portfolio. Historically, these additional fees have been a 1%
management fee and a 10% incentive fee. Because these fees to the fund-of-funds manager are
on top of fees charged by the individual funds, they can signi icantly reduce investor net returns.
Recently, there has been market pressure to reduce hedge fund fees. Rather than the previous
standard of 2 and 20, average hedge fund fees have fallen closer to 1.3% in management fees and
15% in incentive fees. Fund-of-funds fees have also fallen from 1 and 10 and some may charge
only a management fee or a lower management fee combined with a reduced incentive fee.
Similar to categorizing alternative investments, classifying hedge funds can also be challenging.
According to Hedge Fund Research, Inc., there are four main classi ications of hedge fund
strategies:
1. Event-driven strategies are typically based on a corporate restructuring or acquisition
that creates pro it opportunities for long or short positions in common equity, preferred
equity, or debt of a speci ic corporation. Event-driven funds are typically long-biased.

Subcategories are as follows:

– Merger arbitrage. Buy the shares of a irm being acquired and sell short the irm
making the acquisition. Although term “arbitrage” is used, such a strategy is not risk free
because deal terms may change or an announced merger may not take place.
– Distressed/restructuring. Buy the (undervalued) securities of irms in inancial
distress when analysis indicates that value will be increased by a successful
restructuring; possibly short overvalued securities at the same time.
– Activist shareholder. Buy suf icient equity shares to in luence a company’s policies,
with the goal of increasing company value (e.g., by restructuring, change in
strategy/management, or return of capital to equity holders).
– Special situations. Invest in the securities of irms that are issuing or repurchasing
securities, spinning off divisions, selling assets, or distributing capital.
2. Relative value strategies involve buying a security and selling short a related security,
with the goal of pro iting when a perceived pricing discrepancy between the two is
resolved.
– Convertible arbitrage ixed income. Exploit pricing discrepancies between
convertible bonds and the common stock of the issuing companies and options on the
common shares.
– Asset-backed ixed income. Exploit pricing discrepancies among various MBS or
asset-backed securities (ABS).
– General ixed income. Exploit pricing discrepancies between ixed-income securities
of various issuers and types.
– Volatility. Exploit pricing discrepancies arising from differences between returns
volatility implied by options prices and manager expectations of future volatility.
– Multistrategy. Exploit pricing discrepancies among securities in asset classes different
from those previously listed and across asset classes and markets.
3. Macro strategies are based on global economic trends and events and may involve long
or short positions in equities, ixed income, currencies, or commodities. Managed futures
funds may focus on trading commodity futures (these funds are known as commodity
trading advisers, or CTAs) or incorporate inancial futures.
4. Equity hedge fund strategies seek to pro it from long or short positions in publicly
traded equities and derivatives with equities as their underlying assets.
– Market neutral. Use technical or fundamental analysis to select undervalued equities
to be held long and to select overvalued equities to be sold short, in approximately
 equal amounts to pro it from their relative price movements without exposure to
market risk. Leverage may be used.
– Fundamental long/short growth. Use fundamental analysis to ind high-growth
companies. Identify and buy equities of companies that are expected to sustain
relatively high rates of capital appreciation, and short equities of companies expected to
have low or no revenue growth.
– Fundamental value. Buy equity shares that are believed to be undervalued based on
fundamental analysis and sometimes short an index or companies believed to be
overvalued. Exposures to value stocks and small-cap stocks often result.
– Sector speci ic. Identify opportunities within a sector, such as health care, biotech,
technology, and inancial services. Manager expertise within a speci ic sector is believed
to lead to superior returns.
– Short bias. Employ technical and fundamental analysis and take predominantly short
positions in overvalued equities, possibly with smaller long positions but with negative
market exposure overall.

Hedge fund returns have tended to be better than those of global equities in down equity
markets and to lag the returns of global equities in up markets. Different hedge fund strategies
have the best returns during different time periods. Statements about the performance and
diversi ication bene its of hedge funds are problematic because of the great variety of strategies
used. Less-than-perfect correlation with global equity returns may offer some diversi ication
bene its, but correlations tend to increase during periods of inancial crisis.
Characteristics of hedge fund indexes may bias returns and correlations with traditional
investment returns. Because hedge funds might not be included in an index until they have been
in existence for a given time period or until they reach a given size, index returns may exhibit
survivorship bias. Funds that have been successful, so that they have stayed in business for
multiple years or reached a speci ic level of assets under management, tend to be
overrepresented in a hedge fund index, which biases returns upward. Back ill bias refers to the
effect on historical index returns of adding fund returns for prior years to index returns when a
fund is added to an index.
Model values and appraisal values are typically less volatile than market values. To the extent
that funds use models or appraisals for asset valuation and return calculations, both standard
deviations of fund returns and correlations of fund returns with those of traditional investments
will be biased downward. Investors must understand these potential biases when using index
returns to evaluate the risk and return characteristics of hedge funds.

1. An investor who chooses a fund-of-funds as an alternative to a single hedge fund is

to benefit from:
A. lower fees.
B. higher returns.
C. more due diligence.
2. Diversification benefits from adding hedge funds to an equity portfolio may be limited because:
A. correlations tend to increase during periods of financial crisis.
B. hedge fund returns are less than perfectly correlated with global equities.