Top 20 Hedge Fund Interview Questions and Answers

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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 investment 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 funds but is relatively more aggressive in maximizing its returns.

Question #2 - State a few differences between Hedge Funds and Mutual Funds. 

Answer:

Hedge FundsMutual Funds
These funds are not very highly regulated.They are regulated.
The strategies are very aggressive and not necessarily be restricted to a particular sector or product.The strategies are generally limited to investment in the equity market and even to a specific industry.
They are generally targeted to HNI’s and other Large scale investors due to the huge ticket size of the investment.It is focused on retail investors, and the minimum size of the investment is also relatively less.

Also, you can learn about 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 returns. 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 allocation.

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?

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 contract in a lot size of say 50.

Question #9 -  What do you know about 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:  YYes, 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 investments 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.

Clawback

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 strategies and diversification. They are structured as a limited partnership 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 Funds 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 appetite 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 Partner[. 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 LPs 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 GP.

Hedge Fund Strategy Interview Questions and Answers

Question #15 - What is a Long/Short Equity strategy? 

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 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 trading.

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:

Question #17 - What are the differences between forwarding and Future Contracts? 

Answer:  Both Forwards and futures are financial contracts but have some differences:

FuturesForwards
Traded on an exchangeTraded Over the Counter (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 market 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 Forwards.

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 Risk 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 risks 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 liability in case the fund is required to close down and liquidate. 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 option 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 asset. A put option with a strike price that is lower than the market price of the underlying.

ATM is a situation where the strike price of an option is identical to the cost of the underlying security. This situation applies to both calls and puts options.