"Alternative Investments":High-water marks
Which of the following statements concerning the historical record of alternative investments is most likely correct?
A 、The exclusion of returns of funds that have been liquidated leads to an upward bias in index performance.
B 、The use of appraised values instead of market prices leads to an upward bias in volatility.
C 、The inclusion of previous return data for funds that enter the index leads to a downward bias in index performance.
High-water marks are typically used when calculating the incentive fee on hedge funds. They are most likely used by clients to:
A 、avoid prime brokerage fees.
B、 avoid paying twice for the same performance.
C 、claw back the management fees.
A is correct. The exclusion of returns of funds that have been liquidated is called survivorship bias. It is most likely that only poor performers are eliminated and thus reported returns are artificially inflated.
B is incorrect. The use of appraised values instead of market prices leads to a downward bias in volatility.
C is incorrect. The inclusion of previous return data for funds that enter the index is called backfill bias. It leads to an upward bias in index performance.
B is correct. High-water marks help clients avoid paying twice for the same performance. When a hedge fund’s value drops, the manager will not receive an incentive fee until the value of the fund returns to its previous level.
A is incorrect because high-water marks are not linked to prime brokerage fees.
C is incorrect because management fees are paid irrespective of returns.