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Subject 2. Hedge Fund Investment Risk, Return and Diversification PDF Download

In terms of performance, hedge funds are generally viewed as having:

  • Net returns higher than those available for equity or bond investments.
  • A low correlation with conventional investments.

Hedge funds seek to limit market exposure and returns from beta and primarily focus on generating idiosyncratic returns by identifying sources of unique return, or alpha. The primary source of hedge fund excess return is market efficiencies (which may be short lived) and the skills of the manager in leveraging them,

The performance of hedge funds can be attributed to three distinct sources: market data, strategy beta, and alpha.

However, the performance data from hedge fund databases and indices suffer from serious biases such as self-selection bias, instant history bias and survivorship bias.

Hedge Fund Valuation Issues

Questions to ask:

  • Which price to use? Bid price, ask price, average price or estimated value?
  • Any liquidity discounts? The lack of liquidity under extreme market conditions can cause irreversible damage to hedge funds whose strategies rely on the presence of liquidity in specific markets.

Due Diligence

Generally, due diligence refers to the care a reasonable person should take before entering in an agreement or transaction with another party. The due diligence that has to be performed by an institutional investor when selecting a hedge fund is highly specialized and time consuming, given the secretive nature of hedge funds and their complex investment strategies.

The key factors to consider include investment strategy, investment process, competitive advantage, track record, size and longevity, management style, key-person risk, reputation, investor relations, plans for growth, and systems risk management.

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Colin Sampaleanu

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