Learning Module 6
Hedge Funds
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Explain investment features of hedge funds and contrast them with other asset classes — private pooled vehicles, flexible strategies, use of leverage and short selling, performance-based fees, and classification by strategy (equity hedge, event-driven, relative value, opportunistic).
Describe investment forms and vehicles used in hedge fund investments — master-feeder structure, separately managed accounts (SMAs), funds of funds, and hedge fund replication ETFs. Understand liquidity terms (lockup, notice, gates).
Analyze sources of risk, return, and diversification among hedge fund investments — sources of alpha vs beta, performance measurement, biases in hedge fund indexes (survivorship, backfill, selection), and correlations with traditional assets.
1 · Hedge Fund Investment Features
Hedge funds are private pooled investment vehicles that can invest in a wide variety of products. They are distinguished by their investment approach — not the underlying assets. Key characteristics:
Private and lightly regulated: Available only to accredited/institutional investors; less regulatory oversight than mutual funds.
Flexible mandates: Can use leverage, short selling, derivatives, and concentrate positions.
Performance-based fees: Typically "2 and 20" (2% management fee, 20% performance fee) with high-water marks and hurdle rates.
Liquidity constraints: Lockup periods, notice periods, and gates restrict redemptions, allowing managers to pursue illiquid strategies.
Return sources: Seek absolute returns (alpha) rather than relative returns vs a benchmark.
Hedge funds vs Mutual funds: Hedge funds are lightly regulated, use leverage and short selling, charge performance fees, and have limited liquidity. Mutual funds are regulated, generally long-only, charge only management fees, and offer daily liquidity. Hedge funds are for accredited investors; mutual funds are for the public.
Hedge Fund Strategy Classifications
Five broad categories:
Long/Short Equity: Buy undervalued, short overvalued stocks; net long or short bias.
Fundamental Growth/Value: Use fundamental analysis for growth or value spreads.
Short Bias: Net short positions; profit from declining markets.
Merger Arbitrage: Long target, short acquirer — profit from deal spread.
Distressed/Restructuring: Invest in securities of companies near bankruptcy.
Activist: Take large equity stakes to influence corporate policy.
Special Situations: Spin-offs, asset sales, recapitalizations.
Convertible Arbitrage: Buy convertible bonds, short underlying stock.
Fixed Income Arbitrage: Exploit pricing discrepancies in fixed-income markets.
Multi-Strategy: Combine multiple relative value trades.
Global Macro: Top-down bets on interest rates, currencies, commodities, etc.
Managed Futures (CTAs): Trend-following strategies in futures markets (commodities, currencies, bonds, equities).
Fund of Funds: Invests in a diversified portfolio of hedge funds; provides access and diversification.
Multi-Strategy: A single fund with multiple portfolio managers using different strategies.
Equity hedge vs Event-driven: Equity hedge strategies focus on stock selection and market exposure (long/short), while event-driven strategies profit from corporate events (mergers, bankruptcies) that are independent of market direction. Event-driven strategies tend to have lower market beta.
2 · Hedge Fund Investment Forms
Hedge funds can be accessed directly (as an LP in a hedge fund) or indirectly through funds of funds, SMAs, or replication products. Structures are designed for tax efficiency and investor preferences.
Direct Investment Forms
Master-Feeder Structure: Offshore and onshore feeder funds pool capital and invest into a single master fund. Provides tax efficiency for different investor types (US taxable vs non-US).
Separately Managed Account (SMA): A customised portfolio managed by the hedge fund manager but owned directly by the investor. Offers transparency, control, and negotiable fees. Suitable for large institutional investors.
Fund of One: A hedge fund created for a single investor; similar to SMA but with pooled vehicle structure.
Indirect Investment Forms
Funds of Hedge Funds: A portfolio of hedge funds. Provides diversification, access to funds that may be closed, and professional due diligence. Disadvantages: "Double fee" (management and performance fees at both levels).
Hedge Fund Replication ETFs: Use quantitative models to replicate hedge fund returns using liquid assets (stocks, bonds, futures). Lower fees, higher liquidity, but may not fully capture hedge fund returns due to lack of leverage and illiquid assets.
Master-Feeder Structure Example: A US taxable investor invests through the onshore feeder (LP), while a non-US investor uses the offshore feeder (corporation). Both feed into the same master fund, which executes all trades. This structure avoids tax complications for non-US investors while allowing US investors to benefit from partnership tax treatment.
SMA advantages: Customisable mandates, better transparency, efficient capital allocation, higher liquidity, and lower fees (negotiable). However, SMAs are operationally more complex and require greater governance oversight. They are typically used by institutional investors with large commitments.
3 · Risk, Return, and Diversification
Alpha: Manager skill — stock selection, market timing, operational improvements.
Beta: Exposure to systematic risk (market, size, value, etc.). Hedge funds try to minimise beta and maximise alpha.
Strategy Beta: Returns attributable to the specific investment style (e.g., merger arbitrage spread, convertible arbitrage).
Leverage: Amplifies returns but also increases risk.
Survivorship Bias: Failed funds are excluded from indexes, overstating average returns. Only successful funds remain.
Backfill Bias: Funds added to an index retroactively include their (typically strong) historical performance, further inflating returns.
Selection Bias: Inconsistent classification of funds into strategy peer groups; funds with good performance are more likely to report.
Self-Reporting: Funds choose to report performance, often after strong results.
Sources of Return
Performance Measurement & Biases
Impact of biases: Hedge fund indexes can overstate actual average returns by 2-4% annually due to survivorship and backfill biases. Investors should be cautious when using these indexes as benchmarks.
Historically, hedge funds have had low correlations with traditional asset classes. For the 1990–2014 period, the HFRI Fund of Funds Composite had correlations of 0.56 with global stocks and 0.07 with global bonds.
However, in recent years (2015–2019), correlations with equities increased to 0.86, reducing diversification benefits.
Hedge funds can provide absolute returns in both up and down markets, but performance varies by strategy.
Strategies like market neutral and relative value tend to have the lowest market correlation.
Diversification Benefits
FoF annualized return: 7.2%
Global stocks: 6.9%
Global bonds: 6.3%
FoF std dev: 6.0% (vs stocks 16.5%, bonds 5.8%)
Correlation with stocks: 0.56
Correlation with bonds: 0.07
FoF annualized return: 2.48%
Global stocks: 10.41%
Global bonds: 2.42%
Correlation with stocks: 0.86
Correlation with bonds: 0.03
Hedge funds underperformed stocks, correlation increased.
Key takeaway: Hedge funds can provide diversification benefits, but these benefits are not constant. During periods of market stress, correlations with equities tend to increase. Investors should select hedge funds based on their specific strategy and manager skill, not simply for broad diversification.
Leverage risk: Amplifies losses, can lead to forced liquidation.
Illiquidity risk: Lockups and gates restrict redemptions; forced selling can lock in losses.
Operational risk: Fraud, mismanagement, valuation issues (e.g., Madoff, FTX).
Concentration risk: Many hedge funds have concentrated positions.
Risk Considerations