Hedge fund test

Alpha is rare so only the most dedicated and talented can find it. Top portfolio managers take a minimum 50,000 hours full time investing to BECOME skilled and work 100 hour weeks to maintain competence. Such people do NOT manage funds dependent mostly on a high risk index. They score 10/10 on Hedge Fund Test. How will you do?

1) Human resources: You wish to hire a performance rainmaker/new strategy developer. Your shortlist comprises the following candidates. You can only choose one. Who?

i) MBA, CFA with many years experience at prominent bulge bracket white shoe firms
ii) PhD in astrophysics with no financial knowledge
iii) private trader, uneducated, inarticulate and illiterate, made over +100% audited non-leveraged return after 2 and 20 fees in each of last ten years
iv) psychologist with no financial knowledge
v) "Nobel" Prize "winner" in Economic "Sciences"

2) Risk management: If global thermonuclear war, a Richter scale 11 earthquake, a new ice age, an alien invasion and a Texas-sized asteroid strikes earth later today, how much money will you make and how much will "cheap" index funds lose?

i) I pick stocks by analyzing companies, studying income statements, balance sheets and cash flows thereby finding value in a glorious vacuum immune from macro risks
ii) I don't think about my "event-driven" hedge fund being driven by events
iii) Ridiculous scenario so I haven't stress tested for that particular set of risk factors and the 95% VaR number tells LPs all they need to know
iv) Would be up a lot. I always have plenty of shorts and puts. I run a hedge fund. It's my job to prepare for all scenarios however unlikely 
v) Might take an initial hit but make it up trading volatility. I've been investing in space-focused businesses. Planetary bias is as dumb as national bias

3) Market-linked products: You receive a term sheet for a 20% yield AAA rated Iraqi SPAC, SIV-lite, PIK-toggle, Venezuelan Bolivar quanto, digital Bermudan rainbow knockout spreadtion, synthetic Zimbabwe mortgage-backed subprime CDO cubed, CPDO, lumber correlated, Afghan rock-salt linked, orange juice variance swap, carbon credit, catastrophe reinsurance PRDC cliquet reverse floating callable North Korean convertible preferred Delta One Z-tranche. You:

i) Mentally price it up yourself and arbitrage the bank's copula based models
ii) Take all they've got but ask them to restructure the coupon up to 30%, reminding them of the need for marks to - your idea of a - market
iii) Pull the line, inform the SEC, change your name, email address and phone number
iv) Call your favorite search firm and poach the investment bank's product structuring team
v) Tell them to contact the many "sophisticated" investors that love high yield toxic waste rated "AAA" by some clueless firm bribed to rate it

4) Portfolio management: Today your ten biggest long positions all went bankrupt and your ten largest short sells were bought at enormous premiums by overcapitalized private equity funds. You

i) smash your phone, trash the Bloomberg and jump out of the window
ii) write articles for the FT and WSJ on "broken markets", appear on CNBC and schedule several conference keynote gigs
iii) some noise in the markets today - good thing my diversified hedge fund actually is diversified and hedged
iv) move the "distressed" longs to the special situations side pocket and make higher offers on the LBOs
v) shut down the fund, go on a month vacation, then start a new one with a fresh high water mark

5) Quantitative analysis: This morning you were thinking about the turbulence and viscosity of the markets when you found the complete solution to the Navier-Stokes equations. You

i) Publish to worldwide acclaim, a Fields medal and the $1 million Clay mathematics prize
ii) A day's pay? I'd prefer to keep it to myself and perhaps use the ideas in a non-linear model to gain an edge
iii) Navier-Stokes? What's that got to do with making money?
iv) Intellectually satisfying but I already solved the specific cases I needed numerically with a large eddy simulation
v) Forget it and head to work. Just not into quant mumbo jumbo. If it's cheap I buy, if not I short sell. Fundamental analysis and gut trading are what work

6) Deductive reasoning:

A) A googol of fund managers are asked to choose a whole number between zero and a googol. They are each told they will get to manage USD 1 googol at full fees for googol year lockup if the number they choose is half the arithmetic mean of the numbers selected. What number do you pick?

B) A googol of monkeys type at a googol of computers for googolplex years at the Googleplex. What is the probability of a monkey typing out the exact sequence of hedge fund Berkshire Hathaway's annual letters to shareholders?

Hint - A googol is 10^100 which is a tiny number. A googolplex 10^googol is also very small. Most numbers are much larger.

7) Global market knowledge:

A) What is your favorite stock on the Armenia Stock Exchange?
B) Is the Bhutan Ngultrum overpriced or undervalued?
C) What price would you pay for Cuban sovereign yen denominated debt?
D) Denmark's DONG issued a 1,000 year hybrid. At what price do you short?
E) Long Estonia/short Ecuador or vice versa?

8) Market outlook: Investors are urged to bet on equities for the long haul. Stock indices in a few countries have generally risen over time. In several others they fell to zero.

A) What is the likeliest price for the Dow Industrials in one billion years?
B) What would you pay today for a European-style Dow 16,000 strike call option expiring then?

9) Forecasting: To make consistent absolute returns at low risk the one thing that is truly necessary is:

i) To be really, really intelligent. Really
ii) To use common sense since it is not so common
iii) To be a brash, brilliant, street smart, genius star trader
iv) To work harder and more effectively than 99.99% of "professionals"
v) To follow closely what strategists, economists and analysts are saying

10) Experience: From memory what were your ten best and ten worst trades and the exact levels of entry and exit and precise ex ante reasons for the trade? Also from memory what are your ten largest current positions, their average entry price and stop loss point, percentage of total portfolio and what hedges do you have in place?

******** End of Test ********

If you score six sigma above the heronian mean we might contact you. If not the examiners wish you all the best for your career in mutual funds where the fee you "earn" will be vastly higher than the value you deliver.


To source good employees technology companies often use such questions; Google has the Google job test and Microsoft asks people how they would move Mount Fuji. The Hedge Fund Test does similar psychometric analysis for hedge funds.

Other industries have reasonably tough certifications of basic professional knowledge - doctors have MDs, lawyers pass bar exams. But finance has an alphabet soup of too easy "certifications" like CFA, CAIA, CIMA, Series 7, 66 etc. I'd make them all 100x more difficult to upgrade industry standards.

Not surprisingly the world's best investors typically hold none of them, favoring practical experience. Name anyone that learnt to drive or swim from a book. Nobel prize "winners" in economics are infamously negatively correlated with investment acumen, common sense and have terrible track records.

By Veryan Allen Creative Commons License

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