Explanation:
Paul is implementing a strategy to increase the fund's alpha while keeping the fund's beta at 1.0 relative to the S&P 500. However, alpha is a risk-adjusted measure of return, and by reducing systematic risk (via futures contracts), Paul could inadvertently be reducing the potential alpha of the fund. In other words, if the risks that are being hedged out were in fact contributing to the fund's alpha, this approach could diminish the fund's alpha.
A is incorrect because Paul's strategy is specifically aimed at managing the fund's risk profile, not increasing its overall risk level. By hedging against systematic risk not associated with the S&P 500, he is attempting to control the fund's beta exposure, which should, in theory, manage or potentially reduce the overall risk of the fund, not increase it.
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Q.5384 Paul Sampson is a seasoned hedge fund manager at Stellar Hedge Funds. Recently, he has been implementing strategies to increase alpha by taking on opportunities that differ from his benchmark, the S&P 500. As a result, he notices his fund's beta exposure is different from his benchmark. In response to this, Paul uses futures contracts to hedge all systematic risks other than exposure to the S&P 500, such that the portfolio’s beta relative to the S&P 500 is 1.0. However, one of Paul's colleagues, Margaret, has expressed concerns about this strategy, suggesting that it may have unintended effects on the fund's risk and alpha. Given this situation, which of the following best describes the relationship between the risk and alpha in Stellar Hedge Funds?
A
The fund's risk is increased as a result of Paul's efforts to independently manage alpha and beta.
B
Paul's strategy to separate alpha from beta has no significant effect on the fund's overall risk level.
C
The fund's alpha is potentially decreased due to Paul's strategy of minimizing undesired systematic risk.
D
Paul's strategy of using futures to control beta exposure is unlikely to have any effect on the fund's alpha.
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