Charta is on Google Play: practise on the go. Get the app
Charta

Characterise the assorted risks that hedge fund investors face.

FRM® Part II · Risk Management and Investment Management · Risk, Regulation and Organizational Structure · FRM2.IM.9.a

The idea

A hedge fund investor faces more than the market risk in the fund's positions. Market risk covers directional exposure and non-normal tail outcomes, since returns often have negative skew and fat tails, and correlations rise in a crisis. Leverage magnifies gains and losses. Liquidity risk has two sides. One is illiquid holdings that are hard to value and sell. The other is the investor's own restrictions on redemption, such as lock-ups, notice periods, gates and side pockets. Counterparty risk arises because assets sit with prime brokers, and rehypothecated assets can become unsecured claims. Operational risk includes fraud, mispriced positions and weak controls. Model, key-person and style-drift risks add to this. Performance fees give the manager an option-like payoff that rewards risk taking. Smoothed returns understate volatility and overstate the Sharpe ratio. On the exam, match each risk to its source and do not treat reported volatility as the whole picture.

A practice question

From the question bank, with the reason each wrong option is wrong.

An investor reads that a hedge fund's valuation of its positions is done internally and that the manager is also its own administrator. This mainly raises which risk?

  1. Interest rate risk, because internal valuation changes the fund's duration.Why not: Confuses a control weakness with a market risk factor; valuation practice does not change duration.
  2. Credit risk on the fund's bond holdings, because the administrator rates the issuers and none of them is rated independently.Why not: Wrongly assumes the administrator performs credit assessment; its role is NAV calculation and records.
  3. Market risk, because self-valuation exposes the fund to larger price swings.Why not: Valuation by the manager does not change market prices, it changes the reliability of reported NAV.
  4. Operational risk, because weak independent controls make misvaluation and fraud easier. - correct

Independent valuation and administration are basic operational controls. When the manager controls both, misreporting of NAV and misappropriation are easier, which is operational risk, not a market or credit risk factor.

A harder one

A hedge fund holds illiquid securities that it marks with a model, so reported monthly returns show strong positive autocorrelation. Compared with the true economic returns, the reported series will tend to show:

  1. Understated volatility and an overstated Sharpe ratio. - correct
  2. Overstated volatility and an understated Sharpe ratio.Why not: Reverses the effect: smoothing dampens month-to-month changes, so measured volatility falls.
  3. Unchanged volatility, because smoothing leaves the average return and therefore the Sharpe ratio unaffected.Why not: Ignores that the standard deviation, the Sharpe denominator, is reduced by smoothing even if the mean is similar.
  4. Understated volatility but an understated Sharpe ratio, because lower volatility lowers risk-adjusted return.Why not: Gets the direction of the ratio wrong: a smaller denominator raises the Sharpe ratio.

Smoothing spreads price changes across months, lowering measured standard deviation while the average return is similar. The Sharpe ratio, excess return over standard deviation, is therefore overstated, which hides the fund's true risk from investors.

The hardest tier

An investor puts 100 into a fund charging a 2 percent management fee on beginning-of-year NAV and a 20 percent performance fee on profits above the high-water mark, calculated after the management fee. Gross returns are +25 percent, -10 percent and +15 percent in years 1 to 3. The high-water mark starts at 100. The net NAV at the end of year 3 is closest to:

  1. 115.03Why not: Charges a performance fee in year 3 on the gain over the beginning-of-year NAV, ignoring the high-water mark of 118.40.
  2. 117.74 - correct
  3. 114.61Why not: Ignores the high-water mark and also charges the performance fee on the gross gain before deducting the management fee.
  4. 119.82Why not: Ignores both fees in year 3 and reports the gross value.

Year 1: 125 - 2 = 123; fee 0.2 x 23 = 4.6; NAV 118.4 (new high-water mark). Year 2: 106.56 - 2.368 = 104.19, no performance fee. Year 3: 104.19 x 1.15 = 119.82, less management fee 2.08 = 117.74, below 118.40, so no performance fee.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Risk, Regulation and Organizational Structure