Hedge Fund Interview Questions and Answers
In this article, we will take the top 20 Hedge Fund Interview Questions and Answers and will guide you to answer those questions rightly.
We have divided this interview guide into three parts –
- Part 1 – Hedge Fund Interview – Basic Questions and Answers
- Part 2 – Hedge Fund Structure Interview Questions and Answers
- Part 3 – Hedge Fund Strategy Interview Questions and Answers
Hedge Fund Interview – Basic Questions and Answers
Hedge Fund Interview Question#1 – What do you understand by a Hedge Fund?
Answer: A hedge fund is a pool of investmentHedge Fund Is A Pool Of InvestmentA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques. in which investors contribute a sum of money managed by a hedge fund manager. This manager, in turn, will further deploy these funds to maximize their returns. The concept is similar to mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks. but is relatively more aggressive in maximizing its returns.
Question#2 – State a few differences between Hedge Funds and Mutual Funds?
Also, you can learn Mutual Funds here.
Hedge Fund Interview Question#3 – Why are hedge funds not advisable for small-scale retail investors?
Answer: Hedge funds typically have a minimum investment size of around $10 million with risk appetite to lose the entire money if such a situation does arise. The fund manager is involved as a partner in such an investment, but one needs to have a large risk appetite still.
Another reason is that since hedge funds can involve multiple and complex strategies to maximize their returns, it will be difficult for investors to understand and keep track of them.
Question#4 – Tell me something about the 2/20 rule?
Answer: 2/20 is a compensation structure that is employed by the hedge fund managers based on the performance of the hedge fund. This phrase will focus on how the hedge fund managers charge a flat 2% of the total asset value as a management fee and an additional 20% on the total profits which have been earned. Thus, the Management Fee is a mandatory charge, which is essential for running the fund, and performance fees are an award to the fund manager for gaining returns more than the value of the fund.
Question#5 – What are the benefits of investing in hedge funds?
Answer: Some of the benefits of such investments are:
- The consistency of Performance: As the managers are not restricted in their choice of investment strategies and possess the ability to make investments in any class or instrument, they can target for consistent and absolute returnsAbsolute ReturnsAbsolute return refers to the percentage of value appreciation or depreciation of an asset or fund over a certain period. Such assets include mutual funds, stocks and fixed deposits.. The focus does not have to be restricted to outperforming the benchmark.
- Low Correlation: Since a range of investment strategies/financial instruments are being used and they possess the ability to profit in both rising and falling conditions, funds can generate returns that have little correlation to traditional investments.
- Downside Protection: Hedge funds seek protection against declining markets by using various hedging strategies and may involve greater diversification and active asset allocationAsset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals..
Question#6 – Can you explain the concept of Subscription/Redemptions with respect to hedge funds?
Answer: Subscription refers to the investment amount made by an investor to be a part of the hedge fund.
Redemption, on the other hand, is the amount that is liquidated and paid back to the investor on account of exiting the hedge fund or liquidation of the fund.
In either case, the entire amount is not disbursed in a single bucket but is spread out in tranches for smooth movement of the funds. Clarity concerning the same is given in the Offering Memorandum (OM). Redemptions can take anything from 15 to 180 days.
Hedge Fund Structure Interview Questions and Answers
Question#7 – What is a Master-Feeder structure in Hedge Funds?
Answer: A master-feeder fund is a standard structure utilized by the funds for pooling taxable and non-taxable investments raised into a centralized vehicle known as a Master Fund. Thus, the assets are made into separate Feeder funds; one is for the US-based investors, and the other is for the non-US based investors. This amount is then consolidated into the Master fund from which the portfolio investments and trading take place. The feeder fund purchases the shares of the ‘maser fund’ like the stock of any other company. In turn, it receives all the income of the master fund, including interests, gains, and dividends.
Also, have a look at How does a Hedge Fund Work?How Does A Hedge Fund Work?A Hedge Fund is an investment vehicle that pools money from investors & uses a fund manager to operate it and gain maximum returns for them. It utilizes different trading techniques & might specialize in real estate, trade junk bonds, & “long-only” equities etc.
Hedge Fund Interview Question#8 – How does the NAV get calculated?
Answer: The calculation involves the total of the market values of all the securities held by the fund. Thus,
Futures (Long and Short) = Futures Price * Lot size * Number of Contracts
Options bought = Options premium paid * Lot size * Number of Contracts
Options Sold = Market price of the underlying * Lot size * Number of Contracts.
In case of any other derivative exposure, this exposure is proposed to be calculated as the notional market value of the contract.
The lot size is the quantity required to be purchased and suitable for the party, which is offering to buy or sell it. E.g., one purchases an option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised. in a lot size of say 50.
Question#9 – What do you know by Side-pocket Funds?
Answer: These are separate funds for storing illiquid securities from other liquid investments of the funds. Such funds are not available to all the investors and are generally for investors at the time of creation. The investment remains typically locked until these securities are liquidated. The value of these securities may also not be available, and hence its valuation may be done at cost and kept flat across. One can also use prices as per Bloomberg.
Question#10 – Do hedge funds have a lock-up period?
Answer: Yes, hedge funds do have a lock-in period, but the duration differs from one fund to another. Generally, it will depend on the investment strategy. If the manager feels that it will take a year or two for the investments to enhance its value, the same may be kept as a lock-in period during which the investors cannot withdraw the amount of money invested. Normally, a lock-in period of 3 years has been observed in most of the funds.
Hedge Fund Interview Question#11 – Do hedge funds have a clawback provision?
Answer: Yes, hedge funds can have a provision for clawback whereby the Limited Partner is permitted to call back any dividend or carry amount paid during the life of the fund on previous portfolio investmentsPortfolio InvestmentsPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor's risk profile. for normalizing the returns as per the promised/originally agreed percentage. It is not necessarily the entire amount that has to be called back, but a provision is specified through which the hedge fund manager will call back a portion of the amount.ClawbackClawbackA clawback provision is a particular clause included in employment and financial contracts which refers to any money or benefits that have been given out but must be returned due to certain particular circumstances mentioned in the agreement.
Question#12 – What is a Fund of Funds?
Answer: It is a fund which in turn invests further in other hedge funds. The benefit here is that an investor will get the flavor of multiple hedge fund strategiesHedge Fund StrategiesHedge fund strategies are a set of principles or instructions followed by a hedge fund in order to protect themselves against the movements of stocks or securities in the market and to make a profit on a very small working capital without risking the entire budget. and diversification. They are structured as a limited partnershipLimited PartnershipIn a limited partnership, two or more individuals form an entity to undertake business activities and share profits. At least one person acts as a general partner against one limited partner who will have limited liability enjoying the benefits of less stringent tax laws. that offers the advantage of limited liabilities to the investors. The fund manager is responsible for undertaking the due diligence and interacting with all the various fund managers to enhance the return for the investors making sure the minimum involvement of the investors is required. The only drawback is an additional layer of fee gets involved, including the management fees by the FOF and that of the underlying funds.
Also, learn about the Fund of FundsFund Of FundsFunds of fund is referred to as a portfolio of pooled funds from investors that are not directly invested in stocks/securities but rather in hedge funds, mutual funds, stocks, bonds, and other types of securities. in detail here.
Question#13 – What is the importance of an Offering Memorandum?
Answer: An Offering Memorandum is like the Prospectus of a Hedge Fund. It is a legal document that will state the objectives of the hedge fund, risks, terms, and conditions of the fund. All the details are minutely stated in the OM. Hence, the prospective investor is mentioned about the setting up and strategies to be adopted by the fund manager. The minimum investment required and the risk appetiteRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation. is clearly stated in the OM and should be studied by the investor before making any decision. The details of liquidation and clawback provisions are also displayed in the same.
Question#14 – Which entities does a domestic fund structure include?
Answer: The entities included in a domestic fund structure are:
- A Limited partnership as the entity of the fund
- An LLC (Limited Liability Company) to act as an Investment Manager and General PartnerGeneral PartnerA general partner (GP) refers to the private equity firm responsible for managing a private equity fund. The private equity firm acts as a GP, and the external investors are limited partners (LPs).. It is formed in the jurisdiction of the fund sponsor. It is also possible that the Investment Manager and GP be created as two different entities.
Investors become LP of the fund, and the entire trading activities take place within the fund entity. The Management fee and Performance compensation are paid to the Investment Manager/GP.
Also, have a look at the key differences between LP and GPKey Differences Between LP And GPLimited Partners (LPs) are those who have organized and invested funds in a venture capital fund but are not concerned with its day-to-day operations. General partners (GPs), on the other hand, are investment professionals tasked with making decisions about ventures in which they must invest..
Hedge Fund Strategy Interview Questions and Answers
Question#15 – What is a Long/Short Equity strategyEquity StrategyAn equity strategy is a long-short strategy on equity stock which involves taking a long position on those shock which are bullish (i.e., expected to increase its value) and taking a short position on stocks which are bearish (i.e., expected to decline or fall its value) and hence booking a sufficient profit from the difference.?
Answer: It is one of the most vanilla strategies adopted by most of the hedge funds in which the investors go long and short in two competing companies of the same industry based on their respective valuations. The combined portfolio creates more opportunities for stock-specific gains and reduces the market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk. since the buy and sell can offer gains, and the worst case will at least help offset the losses. It is a low-risk leveraged bet and considered an extension of pairs tradingPairs TradingA pairs trading is a trading strategy with statistical and technical analysis. It involves pairing long and short positions on stocks that are strongly correlated with one another to plough a higher profit rate irrespective of the market's moving direction..
Hedge Fund Interview Question#16 – State some of the products in which the hedge fund will normally make its investments?
Answer: The hedge fund is free to make investments into any financial instruments, but it will generally depend on the strategy it adopts. Normally, the investment will be in:
- Equity Shares
- Forwards & Futures
- Swap Contracts
- REIT (Real Estate Investment TrustInvestment TrustAn investment trust is a publicly traded financial institution that operates as a closed-end fund (CEF) and invests in shares or financial assets on behalf of its investors or other organizations. The value of the amount of money invested in an investment trust is dependent by the demand and supply for the invested share or financial asset, as well as the underlying value of the assets owned.)
- Foreign Exchange Trading to take advantage of the change in currency prices
- Private Placements of SharesPrivate Placements Of SharesPrivate placement of shares refers to the sale of shares of the company to the investors and institutions selected by the company, which generally includes banks, mutual fund companies, wealthy individual investors, insurance companies.
Question#17 – What are the differences between forwarding and Future Contracts?
Answer: Both Forwards and futures are financial contracts but have some differences:
|Traded on an exchange||Traded Over the CounterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments. (OTC)|
|The exchange clearinghouse acts as the counterparty to both the parties. This will reduce the risk of the counterparty. The obligation can also be transferred to another party.||No such mechanism of exchange and contract is only between the concerned parties.|
|Positions are marked to marketMarked To MarketMarking to market (MTM) is the concept of recording the accounts, i.e., the assets and liabilities at their fair value or at the current market price, which varies with time rather than historical cost. It helps to represent the company's actual financial condition. daily with margins required to be maintained by participants regularly.||Settlement on delivery, the profit or loss is only realized at the time of settlement. The credit exposure keeps on increasing. Thus, loss resulting from default is more significant.|
Also, have a look at this detailed guide to differences between Futures and ForwardsDifferences Between Futures And ForwardsForward contracts and future contracts are very similar. Still, the key distinction is that futures contracts are standardized contracts traded on a regulated exchange, whereas forward contracts are OTC contracts, which stand for "over the counter.".
Hedge Fund Interview Question#18 – Which are some of the risks associated with Derivatives?
Answer: The risks associated are:
- Market Risk, which arises due to price movements impacting the movement of the stock market.
- Counterparty risk is associated with either of the parties defaulting on executing the contract.
- Liquidity RiskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases. whereby investors close out the derivative positions before maturity. This can cause parties to separate from their liquidity before what was expected.
- Pricing Risk because it is complicated to determine the price of the underlying security.
Also, learn more about hedge fund risksHedge Fund RisksThe main reason for investing in hedge funds is to diversify the funds and maximize the investor's returns. However, high returns come with a cost of higher risk since hedge funds are invested in risky portfolios and derivatives, which has inherent risk, and market risk in it. here.
Hedge Fund Interview Question#19 – How can one trust the fund manager to enhance their returns?
Answer: The fund manager, in many cases, is the General Partner to the hedge fund and will also make a substantial amount of investment to the corpus. This way, they are not only an investor to the fund but will also have unlimited liabilityUnlimited LiabilityUnlimited liability refers to the legal commitment of business owners to be accountable for all business debts if the firm's assets cannot meet its debts or liabilities. In other words, the owners' liability to the business is unlimited. in case the fund is required to close down and liquidated. Thus, if there is a loss, the fund manager will also have to face the same and therefore, will make genuine efforts to enhance the value of the fund.
Question#20 – What is understood by In The Money (ITM), Out of the Money (OTM), and At the money (ATM) option?
Answer: ITM is when the strike price of the call option is trading below the market price of the underlying. If the strike put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. is exceeding the market price of the underlying, it is also ITM. It is just an indication that the choice is worth exercising.
OTM is for describing a call option with the strike price greater than the market price of the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.. A put option with a strike price that is lower than the market price of the underlying.
ATM is a situation where the strike priceThe Strike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. of an option is identical to the cost of the underlying security. This situation applies to both calls and puts options.
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