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CFA® Level I · Alternative Investments · free lesson
Hedge Funds
Hedge funds promise returns that do not depend on rising markets, using leverage, short selling and derivatives under light regulation. This module explains what sets hedge funds apart, the vehicles investors use to access them, the main strategy families and where their returns and risks come from, and why fees, tail risk and biased data make headline hedge fund returns look better than investors' real experience.
What you will learn
1. Explain the features that distinguish hedge funds from traditional investment funds, including their use of leverage and their liquidity terms.
- Absolute return objective, leverage, short selling, derivatives, light regulation and limited transparency.
- Fees: management fee plus incentive fee, usually with a high-water mark.
- Liquidity terms: hard or soft lockups, notice periods, redemption frequency, gates, side pockets and suspensions.
- When a gate binds, redemptions are paid pro rata and the remainder is deferred.
- Prime brokers provide leverage and custody but create counterparty risk; operational due diligence is essential.
2. Describe the vehicles used to invest in hedge fund strategies, including master-feeder funds, funds of funds, separately managed accounts, funds of one and family offices.
- Master-feeder: onshore and offshore feeders invest in one master portfolio to meet different tax needs.
- Fund of funds: diversification, due diligence and access, at the cost of a second layer of fees.
- Separately managed account: transparency, customization and control, but high minimums and costs.
- Funds of one and liquid alternatives offer further trade-offs between control, liquidity and limits.
- US single-family offices are generally exempt from adviser registration and disclose little.
3. Describe the main hedge fund strategy categories and analyze the sources of return and risk in each.
- Equity hedge: long/short, market neutral, short-biased, sector; track gross exposure, net exposure and beta.
- Event driven: merger arbitrage, distressed, activist, special situations; merger arbitrage has a short-put-like payoff.
- Relative value: fixed income, convertible and volatility arbitrage; leveraged, vulnerable to liquidity shocks.
- Opportunistic: global macro (discretionary views) and managed futures (systematic trend following).
- Multi-manager: multi-strategy funds and funds of funds.
4. Evaluate the return, risk and diversification characteristics of hedge funds, including the effect of fees, tail risk and biases in hedge fund return data.
- Fees take a large share of gross returns; funds of funds add a second layer.
- Many strategies have negatively skewed, fat-tailed returns that the Sharpe ratio understates.
- Correlations with equities tend to rise in crises as leverage is cut and investors redeem.
- Survivorship and backfill biases overstate database returns; smoothing understates risk.
- Manager dispersion is wide, so manager selection and operational due diligence are critical.
Module at a glance
- Hedge funds pursue absolute returns with leverage, shorting and derivatives under light regulation.
- Lockups, notice periods, gates, side pockets and suspensions shift liquidity risk to investors.
- Master-feeder serves different tax needs; funds of funds diversify at the cost of double fees; SMAs give transparency and control.
- Strategy families: equity hedge, event driven, relative value, opportunistic and multi-manager.
- Many strategies have negatively skewed, fat-tailed returns, and correlations rise in crises.
- Survivorship and backfill biases inflate reported returns; smoothing hides risk.
- Manager selection and operational due diligence matter more than average strategy returns.
This free module has 4 lessons, 12 practice questions with full explanations.