Answer: Ensure that the hedge fund managers have a sizable amount of their own wealth invested in their fund.

C is correct. The risk sharing asymmetry is a situation where the hedge fund manager fully enjoys the benefits of upside risk (incentive fees), but only partially suffers from the consequences of downside risk (losing incentive fees but not losing their own capital), whereas the investor fully participates in both upside and downside risk. This asymmetry might cause a hedge fund manager to take excessive risk, especially in cases where the hedge fund is far below its high water mark so managers would need to realize a substantial gain to bring the fund back above that mark in order to begin earning incentive fees again. The most prudent approach to mitigating this risk is to ensure that the hedge fund manager has a sizable portion of their own wealth invested with the hedge fund, so that the hedge fund manager would be more conservative in their risk taking and consider both upside and downside risk. A is incorrect. Diversifying across many hedge funds or requiring more frequent position reporting may reduce the overall risk of investing in hedge funds but does nothing to address the risk sharing asymmetry. Managers of each fund may still be motivated to take unreasonable risks to earn incentive fees. B is incorrect. Relying on reputation alone would not solve this risk asymmetry, as is not prudent in any case given examples of hedge fund scandals. D is incorrect. Hedge funds normally provide very little transparency and their reports are prone to return measurement biases.

Author: LeetQuiz .