Traditional mean/variance analysis

Question:HF_Test 2020 Question 1. Traditional mean/variance analysis as proposed by Markowitz shows that for the period 1994-2019 the risk adjusted performance of hedge funds is superior to traditional investments. However, it can be argued that this approach seriously understates the risk of hedge fund investments. Discuss the limitations of the Markowitz approach with particular emphasis on the statistical properties of hedge fund returns. Question 2. Fung & Hsieh (1999) found that linear regression models were less successful at explaining the returns of hedge funds when compared to mutual funds. In order to overcome this, some subsequent research has focussed on using option strategies as explanatory variables with more success. Using your knowledge of the Trend Following and Risk Arbitrage strategies as well as the academic literature, discuss which option strategies best explain the returns of these two strategies and why this might be the case. Question 3. In 2000 only 17% of the assets invested in hedge funds came via funds of funds, by 2007 this proportion had grown to over 40%, however by 2016 the proportion had again reduced significantly to 20%. What factors explained the popularity of funds of funds and why did investors choose to invest via this route rather than directly in the individual underlying hedge funds despite the additional fees? What factors have driven the subsequent reduction in popularity of funds of funds? HF_Test 2018 Question 1. The way in which hedge fund indices are constructed mean that they are potentially subject to several biases and these biases can lead to a distorted view of hedge fund performance. A colleague suggests that to overcome these issues investable hedge fund indices should be used as a benchmark as they are most definitely bias free. Briefly discuss the three key biases, including causes and magnitude. Do you agree with your colleague or is there a better solution? Question 2. Researchers have found that hedge fund returns often display a non-linear relationship with traditional asset classes which makes analysis using linear regression problematic. One way of overcoming these problems is to use option strategies as explanatory variables. Discuss the findings of Fung & Hsieh (2001) for Trend Followers and Mitchell & Pulvino (2001) for Risk Arbitrage highlighting not only what the option strategies are but also why they help to explain the returns of the underlying hedge fund strategies. HF_Test 2017 Question 1. A consultant has prepared an investment proposal for a very large pension fund with $10bn of assets which currently has allocations of 60% to equities, 40% to government bonds. The key points of the consultant’s proposal are: • The fund should allocate 50% to hedge funds and reduce the allocation to government bonds to zero. • The 50% allocation to hedge funds should comprise of 10% Long/Short Equity, 15% Fixed Income Arbitrage, 15% Convertible Arbitrage, 10% Distressed. • To ensure diversification the $5bn allocation to hedge funds should be split between 100 funds ($50m in each). The consultant has based his analysis on a database of funds which is free from any major biases and used mean/variance analysis to arrive at the weights. Briefly describe any issues you see with this proposal drawing on your knowledge of both the academic literature and empirical observations. Question 2. One of the features that distinguish Hedge Funds from Mutual funds is the compensation structure. While mutual funds generally only charge a management fee hedge funds usually also charge an incentive fee which is often accompanied by a high-water mark. Discuss the mechanics of the hedge fund compensation structure and explain its rationale. Do incentive fees lead to any agency issues and if so how can they be resolved?