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CFA Level II · CFA Level II Exam

Hedge Fund Strategies for CFA Level II

Hedge fund strategies are the ways hedge funds try to earn returns: equity hedge, event-driven, relative value, macro and managed futures, and multi-strategy. To solve questions, read the vignette, identify the strategy from the manager's trades, link it to its return drivers and risks, then apply fee or bias logic.

What this chapter covers

This chapter sits in Alternative Investments. It covers how hedge funds are built, how managers are paid, what strategies they run, and why reported performance can mislead. The first part is mechanical. The rest is about recognising a strategy from a description of trades.

In a Level II item set, you will usually get a vignette about a fund or an allocator's review. The questions then ask you to classify a strategy, judge its risk exposures, compute fees or net returns, or spot a bias in an index or track record. You must answer from the facts in the vignette, not from memory of definitions alone.

The chapter links to other parts of the paper. Fee calculations use the same discipline as portfolio return questions. Relative value and macro strategies draw on fixed income and derivatives. Event-driven work touches corporate finance, such as mergers. Bias and due diligence points connect to Ethical and Professional Standards and to Portfolio Construction, where you decide how an alternative fits a portfolio.

Alternative Investments carries a topic weight of 5-10% of the exam, and this chapter is a compact, learnable part of it. Marks come from classification and fee arithmetic, both of which are rule-based once practised. Candidates who skip it lose easy points. Candidates who only memorise lists lose them anyway when the vignette describes trades without naming the strategy.

Hedge Fund Strategies: topics in the order to study them

  1. 1Hedge Fund Structure and FeesStart here because the fund structure, fee terms and return arithmetic are used in every later topic and in the biases section.
  2. 2Equity Hedge Fund StrategiesThese are the most familiar strategies, so they build your habit of mapping trades to a strategy label.
  3. 3Event-Driven StrategiesNext, learn strategies driven by corporate events, which reuse ideas from mergers and restructurings.
  4. 4Relative Value StrategiesThese need fixed income and derivatives ideas, so study them after the simpler equity-based strategies.
  5. 5Macro and Managed Futures StrategiesCompare discretionary macro with systematic futures strategies once you know the other strategy families.
  6. 6Multi-Strategy Funds and Funds of FundsThis topic combines the earlier strategies and adds a second layer of fees and due diligence.
  7. 7Hedge Fund Risk, Return and Performance BiasesFinish with risk and bias, since you need the strategies first to judge which risks and distortions apply.

How to prepare Hedge Fund Strategies

Work from structure to strategies to evaluation. Keep practising with vignettes, because the exam asks you to apply, not recite.

  1. Learn the fee terms first: management fee, incentive fee, hurdle rate, high-water mark and lock-up. Do fee calculations by hand until the order of steps is automatic.
  2. For each strategy, build a one-line card: what the manager buys and sells, what drives return, and what main risk hurts it.
  3. Practise reading short descriptions of trades and naming the strategy before looking at the options. Underline the trade clues in the vignette.
  4. Compare similar strategies side by side, such as merger arbitrage versus distressed investing, or discretionary macro versus managed futures, and note what separates them.
  5. Study the biases (survivorship, backfill, selection and similar) with a one-sentence effect on reported returns for each. Know whether each bias overstates or understates performance.
  6. Finish with full item sets under time. Check every answer against the vignette, and review each miss to see if it was a classification, arithmetic or bias error.

Common mistakes in Hedge Fund Strategies

  • Applying fees in the wrong order or ignoring the hurdle rate and high-water mark.

    Fix: Write the steps each time: starting value, management fee, incentive fee base, then ending value. Check the vignette for the hurdle and high-water mark before computing.

  • Choosing a strategy from its name rather than from the trades described.

    Fix: Identify what is bought, what is sold and what event or mispricing drives the profit, then pick the strategy.

  • Mixing up event-driven and relative value strategies.

    Fix: Ask whether a corporate event triggers the return. If yes, it is event-driven. If the return comes from a pricing gap that should converge, it is relative value.

  • Stating the wrong direction of a bias effect.

    Fix: For each bias, write who is missing or added to the data and how that shifts average returns.

  • Treating reported volatility from illiquid or smoothed valuations as the true risk.

    Fix: When assets are illiquid or priced by the manager, expect understated volatility and correlation, and say so in your reasoning.

  • Ignoring the second layer of fees in funds of funds.

    Fix: When a question asks about net returns to an investor in a fund of funds, include both the underlying and the top-level fees.

Last-day revision: Hedge Fund Strategies

  • Hedge funds typically charge a management fee on assets plus an incentive fee on profits.
  • Check whether the incentive fee is computed before or after the management fee, and whether a hurdle or high-water mark applies.
  • A high-water mark means the manager earns incentive fees only on gains above the prior peak value.
  • Equity hedge strategies include long/short, market neutral and short bias, which differ in net market exposure.
  • Event-driven strategies include merger arbitrage, distressed securities and activist approaches, driven by corporate events.
  • Merger arbitrage typically goes long the target and may short the acquirer in a stock deal; deal failure is the main risk.
  • Relative value strategies exploit pricing gaps between related securities, often using leverage.
  • Macro funds take views on economic variables; managed futures funds usually follow systematic rules in futures markets.
  • Funds of funds add diversification and due diligence but a second layer of fees.
  • Survivorship bias and backfill bias tend to overstate reported index returns.
  • Illiquid holdings can give smoothed returns that understate volatility and correlations.
  • Always answer from the vignette facts, not from a general view of the strategy.

Hedge Fund Strategies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Hedge Fund Strategies: frequently asked questions

How is the hedge fund chapter tested in the Level II exam?

It appears inside an Alternative Investments item set with a vignette and four questions. Expect classification of a strategy from described trades, fee or return calculations, and questions on risks or biases in reported performance.

Do I need to memorise every hedge fund strategy?

You need the main families and what drives each one, as well as their key risks. Focus on telling strategies apart from the trades in a vignette. A one-line card per strategy is usually enough to start with.

Is this chapter calculation heavy?

Not very. The main calculations are fees, hurdle and high-water mark effects, and net returns. They are short but easy to get wrong if you skip a step, so practise them by hand.

What is the best way to revise the biases?

Write each bias with one sentence on how it distorts reported returns or risk, and whether it overstates or understates. Then test yourself on vignettes that describe an index or track record and ask which bias applies.