Investments, tenth edition

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Challenge

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  C H A P T E R  

2 6

 Hedge 

Funds 

949

Equations 26.1 and 26.2) on each of these stocks are independent of each other. What is the 

residual standard deviation of the portfolio?  

   b.  Recalculate the probability of a loss on a market-neutral strategy involving equally weighted, 

market-hedged positions in the 100 stocks over the next month.     

   16.  Return again to Problem 14. Now suppose that the manager misestimates the beta of Water-

works stock, believing it to be .50 instead of .75. The standard deviation of the monthly market 

rate of return is 5%.

    a.  What is the standard deviation of the (now improperly) hedged portfolio?  

   b.  What is the probability of incurring a loss over the next month if the monthly market return 

has an expected value of 1% and a standard deviation of 5%? Compare your answer to the 

probability you found in Problem 14.  

   c.  What would be the probability of a loss using the data in Problem 15 if the manager simi-

larly misestimated beta as .50 instead of .75? Compare your answer to the probability you 

found in Problem 14.  

   d.  Why does the misestimation of beta matter so much more for the 100-stock portfolio than it 

does for the 1-stock portfolio?     

   17.  Here are data on three hedge funds. Each fund charges its investors an incentive fee of 20% of 

total returns. Suppose initially that a fund of funds (FF) manager buys equal amounts of each of 

these funds, and also charges its investors a 20% incentive fee. For simplicity, assume also that 

management fees other than incentive fees are zero for all funds.  

Hedge 

Fund 1

Hedge 

Fund 2

Hedge 

Fund 3

Start of year value (millions)

$100

$100

$100

Gross portfolio rate of return

20%

10%

30%

    a.  Compute the rate of return after incentive fees to an investor in the fund of funds.  

   b.  Suppose that instead of buying shares in each of the three hedge funds, a stand-alone (SA) 

hedge fund purchases the same  portfolio  as the three underlying funds. The total value and 

composition of the SA fund is therefore identical to the one that would result from aggregat-

ing the three hedge funds. Consider an investor in the SA fund. After paying 20% incentive 

fees, what would be the value of the investor’s portfolio at the end of the year?  

   c.  Confirm that the investor’s rate of return in SA is higher than in FF by an amount equal to 

the extra layer of fees charged by the fund of funds.  

   d.  Now suppose that the return on the portfolio held by hedge fund 3 were  2 30% rather than 

 1 30%. Recalculate your answers to parts ( a ) and ( b ). Will either FF or SA charge an incentive 

fee in this scenario? Why then does the investor in FF still do worse than the investor in SA?        

 

 E-INVESTMENTS EXERCISES 

 Log on to  www.hedgeindex.com , a site run by Credit Suisse/Tremont, which maintains 

the TASS Hedge Funds Data Base of the performance of more than 2,000 hedge funds, 

and produces indexes of investment performance for several hedge fund classes. Click the 

Downloads tab (free registration is required for access to this part of the Web site). From 

the Downloads page, you can access historical rates of return on each of the hedge fund 

subclasses (e.g., market neutral, event-driven, dedicated short bias, and so on). Download 

5 years of monthly returns for each subclass and download returns on the S&P 500 for the 

same period from  finance.yahoo.com . Calculate the beta of the equity-market-neutral 

and dedicated short bias funds. Do the results seem reasonable in terms of the orienta-

tion of these funds? Next, look at the year-by-year performance of each hedge fund class. 

How does the variability of performance results in different years compare to that of the 

S&P 500? 

bod61671_ch26_926-950.indd   949

bod61671_ch26_926-950.indd   949

7/25/13   2:04 AM

7/25/13   2:04 AM

Final PDF to printer

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Visit us at www

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950 

P A R T   V I I

  Applied Portfolio Management