Question #36 - Reading 34 Hedge Fund Strategies

Reading: Reading 34 Hedge Fund Strategies

PDF File: Reading 34 Hedge Fund Strategies.pdf

Page: 15

Status: Correct

Correct Answer: A

Shared Context

of 49 The key factors an insurance settlements portfolio manager must successfully analyze include: A) the underlying interest rate on the policy, the early termination provisions of the contract, and the government bond yield curve. B) expected policy cash flows, ongoing premium payment obligations, and the eventual death benefit to be received. C) the probability that the insurance company will face financial pressure, the demeanor of the policy holder, and the age of the policyholder. Bobby Berg is an investment analyst at Conduit Asset Management (CAM), a manager of a large fund of hedge funds. Berg is performing research into investments relating to catastrophe reinsurance and life settlements, a relatively new sector for hedge fund investment. Berg meets with Michael Stern, a hedge fund manager who specializes in investments in the insurance sector. Stern discusses recent life settlement opportunities presented by insurance brokers and discusses their relative merits, the details of which are displayed in Exhibit 1. Exhibit 1: Selected Life Settlement Opportunities Insurance Pool Surrender Value ($m) Annual Premium (Percentage of Benefit) Life Expectancy of Pool vs. Mortality Tables A 10.4 0.95% Longer B 9.2 0.87% Shorter C 12.8 1.25% Shorter Berg is performing due diligence on hedge fund managers that could potentially be added to the existing fund of hedge funds portfolio. She is aware of a recent motion passed at an investment committee meeting, which recorded the following short-term tactical objectives: Increase liquidity Decrease leverage Lower exposure of the fund to tail risks, such as acute credit weakness in markets Berg considers how best to achieve these objectives when considering the existing style allocation of CAM. CAM provides the following information on its fee structure to potential clients: CAM charges 1% management fee and 5% incentive fee The average underlying fund charges 1.5% management fee and 17.5% incentive fee A client of CAM asks Berg about the relative merits of a fund-of-funds structure versus a multi-manager hedge fund structure. They are specifically interested in which structure would give the best result for investors, with respect to the following: Operational risk Speed of tactical asset allocation Fee netting risk

Question

Using the data in Exhibit 1 and assuming that all other features of Insurance Pool A, Insurance Pool B, and Insurance Pool C are equivalent, the life settlement investment opportunity with the best expected return is most likely to be:

Answer Choices:

A. C) Pool

B. Pool

C. Pool B

Explanation

Life settlement investments involve the hedge fund buying existing insurance policies from insured lives, paying the premium for the remainder of the contract's life, and then receiving the payout of benefits on the death of the original policyholder. Hedge funds will prefer pools of insurance contracts that have a low surrender value (defined as the value the insured lives could receive from the original insurance company if they cancel their contract) because this implies that policyholders would be happy to sell their insurance contracts for a relatively lower amount. Hedge fund managers would prefer insurance pools with a lower premium as a percentage of benefit because they will have to pay this for the remainder of the life of the original policyholder. Hedge funds would also prefer contracts relating to lives with lower life expectancies because they will receive benefit payouts sooner if the original policyholders die earlier. Pool B meets these conditions of lower surrender value, lower annual premium, and shorter life expectancy.

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