A. Acronyms Define each of the following acronyms FoHFs: PPNs: B. Calculations 1

Question

A. Acronyms Define each of the following acronyms FoHFs: PPNs: B. Calculations 1. At the start of Year 1, the hedge fund run by DKE Management inc. had $100 million in net assets. DKE is entitled to an annual incentive fee of 8% of the fund's return, subject to a high water mark of $100 million. Assuming no contributions or withdrawals from the fund over the next 2 years, what incentive fees will the managers collect at the end of Year 2 if the fund returns-8% in Year 1 and 22% in Year 2? Ignore the effect of management fees and expenses

Explanation / Answer

Answer A

FOHF – Fund of Hedge Funds also know as Funds of Fund.

It is an investment strategy wherein, an investor holds a portfolio comprising of different investments like stocks, bonds etc, instead of holding individual securities. This type of fund is managed by investment managers who have expertise in the related field.

They can be categorized into:

These type of funds offer greater diversification benefits to small investors who cannot directly invest in Hedge Funds. However, the major drawback of the FOF is the fee paid both at the FOF level and for the investment fund.

PPN – Principal Protected Note.

It is an investment best suited for a risk averse investor. It is somewhat a fixed income security that guarantees a minimum return equal to the initial principal amount. These notes are also known as Principal Protected Products.

Answer B:

Let us first understand what is High Water Mark Provision

High water mark is the highest value that an investment fund achieves during the course of the fund performance. It is usually acts as a benchmark to judge the performance of the portfolio or investment managers. The main job is to ensure that the manager do not get paid for the poor performance results and only receive the compensation or bonus if the fund value reaches above the high water mark value.

In our question, the High Water Mark (HMW) is $100 mn and the incentive fee is 8% which is only paid if the manager performs well and the value of the fund reaches above $100 mn.

Year 1:

The fund returns -8% bringing the portfolio down to $92 mn.

$100 @ (8%) = $8 mn (Loss)

Year 2:

The fund returns 22% bringing the portfolio value to $112.24 mn.

$92 @ 22% = $20.24 mn (Profit)

Since the HMW is at $100 mn, the manager will only be given incentive for the difference between $112.24 mn and $ 100 mn.

Therefore, the manager will receive the compensation as $12.24 mn @ 8% = $979,200.

Answer C

In this question the total net exposure to the client is $170,000. The reason is that he is long BBD with $100,000 and short CBA with $70,000.

Now, let’s suppose the price of BBD falls to Zero due to some unforeseen circumstances the investor will lose $100,000 for its exposure to BBD. And if the stock price of CBA increases, he will have to purchase the stock from the market at a higher price in order to fulfil his commitment for the short position.

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