A US life insurer reduced its public-bond holdings by $40 billion in five years and reallocated to private credit. The yield pickup is 200-300bps; the liquidity haircut is hard to measure. The exam tests whether you can describe what private credit IS, what makes its return profile look smoother than public credit, and where the hidden risks sit.
Equity strategies dominate the hedge fund universe. Long-short equity holds longs in undervalued names and shorts in overvalued names; net market exposure varies. Equity market neutral targets zero beta with paired long-short trades. Dedicated short bias holds net short positions and earns from declining markets, a tiny strategy in a generally rising market.
Event-driven strategies trade corporate events. Merger arbitrage buys the target and shorts the acquirer (in stock deals) to capture the spread between current price and deal price. The risk is deal break: if the merger fails, the target falls hard. Distressed securities buy debt of bankrupt or near-bankrupt companies; covered in IM4 due to the diligence and legal complexity.
Common mistakes
- Treating reported private credit volatility as true risk. Quarterly NAV marks smooth observed returns. True volatility is roughly 2-3x reported. Trap: a question shows private credit with reported σ of 3% versus public HY at 8% and asks "which is riskier?", the right answer is "they are similar after un-smoothing."
- Confusing TVPI with IRR. TVPI is a multiple (total value divided by paid-in); IRR is a rate. A 1.5x TVPI over 5 years is approximately 8.4% IRR; a 1.5x TVPI over 10 years is 4.1% IRR. Trap: candidates pick the higher TVPI as "better return" without checking duration.
- Using the master-feeder structure as a "performance attribution device." Master-feeder is purely a tax structure to keep US tax-exempt and offshore investors out of UBTI. Trap: a distractor says "master-feeder enables aggregated performance reporting", wrong. Aggregated reporting comes from the master fund's books, not the structure.
Bottom line
- Hedge fund strategies divide into equity (long-short, market neutral, dedicated short), event-driven (merger arb, distressed, activist), macro (global macro, managed futures), and arbitrage (convertible, fixed-income, statistical).
- Convertible arb is positive carry, positive gamma, short credit spread (it earns from volatility); merger arb is positive carry with deal-break tail risk (it suffers from volatility).
- Hedge fund regulation historically light; post-2008 systemic-risk concerns drove Form PF, AIFMD reporting, and prime-broker exposure caps, reducing opacity but not concentration.
- Systemic-risk channels for hedge funds are counterparty concentration, crowded trades, and run risk.
Exam shortcut
When the question asks "what is the risk of private credit?", the answer is almost always related to opacity, smoothing, or concentration, NOT credit losses (which are similar to HY). When the question asks about hedge fund strategy match-ups, look for the return-profile signature: short volatility (merger arb, convertible arb), long volatility (managed futures), low correlation (macro), high beta (long-short equity).
The full lesson (about 3,362 words, 22 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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