Chartered Financial Analyst (CFA) Practice Exam Level 2

What does a higher cost structure in hedge funds often lead to?

1. Higher returns

2. Lower investor satisfaction

3. Increased investment transparency

4. Greater investor security

The correct answer is: Lower investor satisfaction

A higher cost structure in hedge funds often leads to lower investor satisfaction. This is primarily due to the fact that high fees, which can include management and performance fees, can erode the overall returns that investors receive. When investors see that a significant portion of their returns is being consumed by fees, their perception of the fund’s value diminishes, leading to dissatisfaction. Furthermore, hedge funds are typically expected to generate alpha, or excess returns above a benchmark, to justify their high fees. If these funds fail to deliver returns that adequately compensate for their costs, investor dissatisfaction can further increase. Essentially, higher costs can create a disconnect between investor expectations and the actual performance of the hedge fund, leading to feelings of disappointment and frustration. In contrast, while the cost structure may not directly correlate with transparency or security, those factors tend to be viewed independently. The lack of pricing transparency associated with hedge fund fees can also contribute to investor dissatisfaction, as investors may not fully understand what they are paying for and whether the costs are justified. Overall, the effect of a higher cost structure primarily manifests as a reduction in investor satisfaction, highlighting the critical importance of aligning fee structures with performance expectations.