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

An equity market neutral fund is constructed to be dollar neutral and beta neutral, but it suffers large losses during a sudden market rotation in which highly shorted, low-quality stocks rally sharply while the fund's long holdings lag. Which risk best explains the losses?

The losses are best explained by unintended factor exposure and crowding, leading to a short squeeze. Dollar and beta neutrality do not hedge style factors such as quality or short interest, so a rally in heavily shorted weak stocks can hurt a market neutral fund.

  1. AUnintended factor exposure and crowding, producing a short squeezeCorrect
  2. BResidual market beta from the long book
  3. CInterest rate duration risk of the shorts
  4. DCurrency risk on the long positions

Explanation

Beta and dollar neutrality do not remove exposure to style factors such as quality, momentum or short interest. A rally in heavily shorted, low-quality names reflects factor reversal and crowded-short squeezes. The fund is stated to be beta neutral, so market beta is not the cause.

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