Hedge Fund

Which hedge fund feature most directly limits an investor's ability to withdraw money on short notice?

1. A.The performance fee charged on profitsThe incentive fee reduces net returns; it does not restrict withdrawal timing.
2. B.The fund's use of derivativesDerivatives affect the risk profile of the strategy, not the investor's redemption rights.
3. C.The lock-up period and limited redemption windowsCorrect. Redemption restrictions are what physically prevent the investor from getting cash out.
4. D.The high minimum initial investmentA high minimum limits who can get in, not how quickly an existing investor can get out.

Why: A lock-up period contractually bars redemptions for a stated stretch after investment, and after the lock-up most funds allow withdrawals only on quarterly or annual redemption dates with advance notice.

A hedge fund's classic '2 and 20' fee structure means:

1. A.2% of assets plus 20% of profitsCorrect - management plus performance fee.
2. B.20% of assets onlyThis attaches the 20 to the asset base and drops the management fee entirely. The 20 is a share of profits, not of assets; an annual 20% levy on assets would exceed what most funds earn in a good year.
3. C.No feesThe phrase names two separate charges, so a no-fee reading contradicts the term itself. Hedge funds sit at the expensive end of the fee spectrum, which is a large part of why the structure is worth memorizing.
4. D.2% total, no performance feeThis gets the first number right and then discards the second. The 2 is the annual management fee charged on assets, and the 20 is the incentive fee taken from profits, so omitting the performance piece understates the true cost substantially.

Why: A 2% annual management fee plus 20% of profits (a performance/incentive fee).

Compared with investing directly in a single hedge fund, a REGISTERED fund of hedge funds typically offers a retail investor:

1. A.Lower total fees than a direct hedge fund investmentExactly backwards - the wrapper ADDS its own management fee on top of the underlying funds' fees.
2. B.Elimination of hedge-fund risk through diversificationSpreading across managers dilutes idiosyncratic risk but the underlying leverage, shorting, and illiquidity risks remain.
3. C.The same daily liquidity as an exchange-traded fundFunds of hedge funds commonly limit redemptions to periodic windows - nothing like intraday ETF liquidity.
4. D.Lower investment minimums and manager diversification, at the cost of layered feesCorrect. Access and diversification are the benefits; paying fees at both the fund and underlying-fund level is the price.

Why: A registered fund of funds provides diversified exposure to multiple hedge fund managers at far lower minimums - but the investor pays two layers of fees: the underlying funds' fees plus the wrapper's. Registration does not make the underlying strategies liquid or low-risk. The clue is registered plus retail. Review: Pooled Investment Vehicles.

A hedge fund borrows heavily to increase the size of its positions. The effect of that leverage is to:

1. A.Increase potential gains while leaving losses unchangedThe one-sided view of leverage — the single most costly misconception about hedge funds.
2. B.Magnify both potential gains and potential lossesCorrect. Borrowed money scales results in both directions.
3. C.Reduce volatility by spreading capital over more positionsLeverage increases exposure; it is not a diversification technique.
4. D.Guarantee a return above the borrowing costNothing guarantees the strategy earns more than the cost of borrowing; that gap can be negative.

Why: Leverage magnifies results in both directions. It amplifies gains when positions move favorably and amplifies losses when they do not, and it can force liquidation at the worst moment.