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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A market neutral equity fund is constructed to be neutral to market beta, sector and size exposures. Which risk is most characteristic of such a strategy during a sudden deleveraging by many similar quantitative funds?

The characteristic risk is crowded-trade losses. When many similar quantitative funds hold the same longs and shorts and are forced to deleverage, longs fall and shorts rise together, hurting the portfolio even though it is neutral to market, sector and size factors.

  1. ACrowded-trade losses as common long and short positions move against the funds simultaneouslyCorrect
  2. BLarge losses driven by a broad equity market decline
  3. CLosses driven by a parallel shift in interest rates
  4. DGains from rising correlation among all stocks

Explanation

Because the funds are factor neutral, market declines matter little. When many funds hold similar positions and deleverage, longs fall and shorts rally together, creating losses unrelated to the market, as in August 2007.

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