CFM Hedge Fund Strategies & Operations 5 — Questions and Answers
Question 1: A hedge fund uses a 'portable alpha' approach by overlaying an alpha-generating strategy onto a passive beta exposure. The primary goal is to:
- Eliminate all market beta from the portfolio
- Generate excess returns above a benchmark while maintaining the desired beta exposure (Correct answer)
- Convert fixed income returns into equity-like returns
- Hedge currency risk in an international portfolio
Correct answer: Generate excess returns above a benchmark while maintaining the desired beta exposure
Portable alpha separates alpha generation from beta exposure, allowing a manager to deliver benchmark returns plus excess alpha from an independent strategy.
Question 2: A hedge fund's Sharpe ratio is 1.5. A new strategy has a Sharpe ratio of 0.8 but zero correlation to the existing portfolio. Adding the new strategy will most likely:
- Reduce the portfolio Sharpe ratio because the new strategy has a lower Sharpe
- Increase the portfolio Sharpe ratio due to diversification benefits (Correct answer)
- Have no effect on portfolio Sharpe because Sharpe ratios average linearly
- Reduce portfolio returns since the new strategy underperforms
Correct answer: Increase the portfolio Sharpe ratio due to diversification benefits
When a new strategy has zero correlation to the existing portfolio, its addition improves overall portfolio Sharpe through diversification regardless of its individual Sharpe ratio.
Question 3: In the context of hedge fund risk management, 'factor decomposition' is used to:
- Identify which systematic risk factors drive portfolio returns and exposures (Correct answer)
- Decompose performance fees from management fees in the fund's P&L
- Break down the fund's investor base by geography and type
- Allocate operational costs across different trading strategies
Correct answer: Identify which systematic risk factors drive portfolio returns and exposures
Factor decomposition attributes portfolio returns and volatility to systematic exposures such as market, size, value, momentum, and sector factors.
Question 4: A hedge fund structured as a Delaware Limited Partnership has a 'key man clause.' This clause typically allows investors to:
- Replace the general partner with a majority vote
- Redeem capital without penalty if a specified key portfolio manager departs (Correct answer)
- Waive performance fees if the key manager underperforms
- Transfer their LP interests to other investors freely
Correct answer: Redeem capital without penalty if a specified key portfolio manager departs
A key man clause gives investors the right to redeem without lockup penalties if a designated key portfolio manager leaves the fund.
Question 5: The 'information ratio' differs from the Sharpe ratio in that it measures:
- Total return relative to total risk
- Excess return over a risk-free rate per unit of total volatility
- Active return over a benchmark per unit of tracking error (Correct answer)
- Return per unit of maximum drawdown
Correct answer: Active return over a benchmark per unit of tracking error
The information ratio measures the consistency of active management by dividing alpha (return above benchmark) by tracking error (active risk).
Question 6: A commodity trading adviser (CTA) using a trend-following strategy would most likely perform well during:
- Choppy, range-bound markets with frequent reversals
- Prolonged trending markets in commodities, currencies, or rates (Correct answer)
- High-dividend equity bull markets
- Tight credit spread environments
Correct answer: Prolonged trending markets in commodities, currencies, or rates
Trend-following CTAs rely on sustained directional price movements to generate returns; they struggle in mean-reverting or choppy markets.
Question 7: A hedge fund's 'high-water mark' provision ensures that:
- Investors pay performance fees only on returns that exceed the risk-free rate
- The manager collects performance fees only after recovering previous losses for each investor (Correct answer)
- Fund AUM never falls below a minimum threshold
- The fund's leverage cannot exceed peak historical levels
Correct answer: The manager collects performance fees only after recovering previous losses for each investor
The high-water mark requires the fund to recover all prior losses and exceed the previous NAV peak before performance fees can be charged again.
CFM Hedge Fund Strategies & Operations 5
A hedge fund uses a 'portable alpha' approach by overlaying an alpha-generating strategy onto a passive beta exposure.
The primary goal is to: