CFA Level 3 – Alternative Investments Session 13

CFA Level 3 – Alternative Investments, Session 13 – Reading 31

(Notes, Practice Questions, Sample Questions)

1. With respect to the role of alternative assets in a portfolio, it can be best described as exposure to:

A)special investment strategies.
B)unique asset classes and/or special investment strategies.
C)unique asset classes only.

Explanation: We can categorize alternative investments into three categories corresponding to the role they play in the portfolio.
Exposure to asset classes that stocks and bonds cannot provide.
Exposure to special investment strategies such as those used by hedge funds.

Investments that use both special strategies and unique asset classes (e.g., funds that invest in private equity and distressed securities)

2. Special due diligence issues such as valuation, credit analysis, and financial structure are most likely associated with investments:

A)in managed futures.
B)in distressed securities.
C)made indirectly in real estate.

Explanation: Distressed securities investing requires due diligence with respect to business valuation, credit analysis, and assessing the company’s problems and financial structure

3. The structure, explanation of performance data, and style and strategy are special due diligence issues most associated with:

A)hedge funds.
B)direct real estate investing.
C)distressed securities

Explanation: Due diligence in hedge funds should include an inquiry into the following list: the structure of the hedge fund, the strategy and style of the hedge fund, performance data since inception with explanations, risk measures, research, administration, and legal issues

4. With respect to information efficiency and potential for diversification, in comparing alternative investments to exchange traded stocks, the markets for alternative investments are:

A)less informationally efficient and provide more opportunity for diversification.

B)less informationally efficient and provide less opportunity for diversification.
C)more informationally efficient and provide more opportunity for diversification

Explanation: Alternative investments can provide exposure to unique risks and trading strategies and thus provide good diversification to a stock and bond portfolio. The markets for alternative investments are informationally less efficient than most stock markets

5. With respect to due diligence costs and liquidity, in comparing alternative investments to exchange traded stocks, the markets for alternative investments have:

A)less liquidity and higher due diligence costs.
B)less liquidity and lower due diligence costs.
C)more liquidity and higher due diligence costs

Explanation: The common features are: low liquidity, provide good diversification, due diligence costs are high, difficult appraisals, and the markets for alternative investments are informationally less efficient than most stock markets

6. Which of the following is least likely to be a due diligence checkpoint in the selection process of active managers of alternative investments?

A)The geographic location of the office with respect to the geographic locations in which the manager invests.
B)The service providers like lawyers and ancillary staff working for the manager’s firm.
C)Market opportunity the manager seeks to exploit

Explanation: The due diligence checkpoint list does not mention the geographic location of the offices

7. Jill Beaman, CFA, notices that for wheat futures there is a downward-sloping term structure of futures prices. Beaman should recognize that this would be associated with:

A)normal backwardation and a positive roll return.
B)normal backwardation and a negative roll return.
C)contango and a positive roll return

Explanation: Normal backwardation, when it exists, produces a downward-sloping term structure of futures prices. Such a condition predicts a positive roll return. If the term structure is positive, which is a result of contango, the roll return would be negative

8. With respect to a commodity futures contract, the collateral return:

A)is the opportunity cost of storing the commodity.
B)is highly correlated with the spot rate.
C)represents the return on a fully hedged commodity position which should be approximately the risk-free rate

Explanation: The collateral return or “collateral yield” is the result of the no-arbitrage assumption that if an investor is long a contract and invests an amount in T-bills that will be equal to the amount required to pay for the required purchase at the maturity of the futures contract. Such a fully-hedge position should earn the risk-free rate

9. Jill Beaman, CFA, has recorded the components of the return on a commodity futures contract. The return on the futures contract is $17, the spot return is $9, and the roll return is $5. What is the collateral return?

A)$6.89.
B)$31.00.
C)$3.00.

Explanation: Total return = spot return + collateral return + roll return.
Collateral return = total return − spot return − roll return

10.1 Jake Billingsly, CFA, and Paula Sloop, CFA, are investigating alternative investments for their clients. They have both institutional and private wealth clients, and Billingsly and Sloop have investigated the special issues that alternative investments raise for investment advisers of private wealth clients. When compared to institutional clients, Billingsly says that decision risk is higher for private wealth clients, and Sloop says that tax issues are generally more complex for private wealth clients.
Billingsly and Sloop review the principal classes of alternative investments, and they compare the features of real estate, private equity, commodity investments, hedge funds, managed futures, buy-out funds, infrastructure funds, and distressed securities. Some of their clients have been interested in venture capital funds, but Billingsly and Sloop think that buy-out funds may be a better alternative. Compared to venture capital, Billingsly says that buy-out funds tend to have lower leverage. Compared to venture capital, Sloop says that buy-out funds tend to have steadier cash flows.
Some of the institutional clients have held venture capital investments for several years. Billingsly and Sloop anticipate some of these investments are approaching the exit stage. As they look over the investments held by the institutional clients, they anticipate that the institutions’ investments in venture capital will most likely realize their value through one of four ways: i) the entrepreneurs buying out the venture capital investment from the venture capitalists, ii) a merger with another company, iii) an acquisition by another company, or iv) an initial public offering when the company in which the venture capital is invested and goes public (IPO).
Commodities are another area of interest. Many of both the private wealth clients and the institutional investors have asked if commodities would be good hedges against inflation. To accommodate the demand for inflation hedges, Billingsly and Sloop arrange for the clients to take long positions in energy, livestock, industrial metals, and precious metals. They want to use futures contracts that have the potential for the highest roll yield with a buy-and-hold strategy. They specifically focus on the topics of backwardation and contango and plot the roll returns for historical commodity futures over their respective lives. Billingsly and Sloop notice that the returns generally change over the life of each commodity futures contract and take this into account in their investment plans.
Billingsly and Sloop look at different types of hedge funds. They analyze the different styles and the fees the managers charge. They notice that one of the most popular hedge fund strategies attempts to identify overvalued and undervalued equity securities. The strategy takes long and short positions, but the goal of the fund is not necessarily to be market neutral or industry neutral. They find that the fee structures generally have three components. There is also a feature called a high water mark, and they discuss the rationale for the high water mark.Billingsly makes a statement about the decision risk and Sloop makes a statement about tax issues of private wealth clients compared to institutional clients. With respect to these statements:

A)both Billingsly and Sloop are incorrect.
B)Billingsly is correct and Sloop is incorrect.
C)both Billingsly and Sloop are correct

Explanation: When compared to institutional clients, decision risk is higher for private wealth clients, and tax issues are generally more complex for private wealth clients.

10.2 Billingsly and Sloop compare buy-out funds to venture capital. With respect to the statements they make:

A)Billingsly is correct and Sloop is incorrect.
B)Billingsly is incorrect and Sloop is correct.
C)both Billingsly and Sloop are correct.

Explanation: Buy-out funds tend to use more leverage, so Billingsly is wrong, but Sloop is correct in that the cash flows are steadier.

10.3 Of the ways that Billingsly and Sloop estimate that firms invested in venture capital might exit and realize the value of their investment, the one that is not among the usual methods of exit is:

A)entrepreneurs buying out the venture capital investment from the venture capitalists.
B)an IPO.
C)a merger with another company.

Explanation: Mergers, acquisitions and IPOs are the usual methods. Entrepreneurs buying out investors is not a likely method of exit for the venture capitalist

10.4 With a futures buy-and-hold strategy, a positive roll yield would be associated with a commodity yield curve that exhibits:

A)backwardation, and the return decreases as it approaches maturity.
B)contango, and the return increases as it approaches maturity.
C)backwardation, and the return increases as it approaches maturity.

Explanation: A roll yield from a buy and hold strategy is only possible when there is backwardation. The return increases as the contract approaches maturity.

10.5 The hedge fund style that Billingsly and Sloop find to be the most popular, and that they describe, would most likely be categorized as:

A)hedged equity.
B)convertible arbitrage.
C)merger arbitrage.

Explanation: Identifying overvalued and undervalued securities without focusing on making the fund market or industry neutral is called the hedge equity style.

10.6 The rationale for the high water mark is to:

A)make sure managers get paid when the value of the fund increases steadily.
B)prevent managers from getting overpaid when the value of the fund increases steadily.
C)prevent managers from getting overpaid when the value of the fund oscillates.

Explanation: The high water mark prevents a manager from getting paid twice for the positive increase in the fund’s value. If a fund goes from $10 million in value to $11 million in value, the managers should get paid an incentive fee on the $1 million move. If the $11 million is set as a high water mark, the manager will not be paid an incentive fee if the fund declines below $11 million and then rises back to that value.

11. Which of the following commodities is least likely to have returns that are positively correlated with inflation?

A)Corn.
B)Energy.
C)Industrial metals.

Explanation: Nonstorable agricultural commodities returns have returns that are negatively correlated to inflation. Storable commodities like energy and metals have returns that are positively correlated with inflation.

12. As an investment, the commodity energy is:

A)nonstorable and a hedge against inflation.
B)storable and a hedge against inflation.
C)nonstorable but not a hedge against inflation.

Explanation: Commodities that are not agricultural products tend to be storable and hedges against inflation. Energy is both storable and its return has been correlated with inflation

13. Commodities can be categorized into storable and nonstorable. Which category, if any, should an analyst recommend as a hedge against inflation?

A)Both storable and nonstorable commodities.
B)Nonstorable commodities.
C)Storable commodities.

Explanation: Storable commodities like energy and metals have returns that are positively correlated with inflation. The positive correlation means the real return will tend to remain positive even when inflation increases.

14. A hedge fund that focuses on earning returns from mergers, spin-offs, and takeovers would be most accurately placed in which style category?

A)Equity market neutral.
B)Merger arbitrage.
C)Hedged equity.

Explanation: Merger arbitrage focuses on returns from mergers, spin-offs, takeovers, etc… For example, if company X announces it will acquire company Y, the manager might buy shares in Y and short X

15. A hedge fund that takes positions in convertible bonds or convertible preferred stock and then takes other positions in the underlying stock would be most accurately placed in the style category:

A)convertible arbitrage.
B)equity market neutral.
C)distressed securities.

Explanation: Convertible arbitrage usually takes positions in convertible bonds or preferred stock as well as warrants, etc…, and then takes other positions in the underlying stock

16. William Jones, CFA, has a client who wants to invest in a hedge fund that has the strategy of investing in equities and has among its goals the elimination of systematic risk. Jones has found two funds that he thinks are well run: the Marius Fund that uses an equity market neutral strategy and the Hera Fund that uses a hedged equity strategy. Given the client’s stated preferences, Jones should recommend:

A)either fund.
B)the Hera Fund only.
C)the Marius Fund only.

Explanation: Equity market neutral is usually the attempt to exploit price discrepancies through long and short positions. This strategy also has the goal of the systematic risks canceling because of the long and short positions. Hedged equity strategies take long and short positions in under and overvalued securities, respectively, like equity market neutral strategies. The difference is that hedged equity strategies do not focus on balancing the positions to eliminate systematic risks

17. In the structure of a hedge fund, which of the following is least accurate concerning a lock-up period? A lock-up period:

A)establishes a minimum investment period for each investment.
B)establishes a cap on new investment.
C)establishes exit windows.

Explanation: A lock-up period is a common provision in hedge funds. Lock-up periods limit withdrawals by requiring a minimum investment period, e.g., 1-3 years, and designating exit windows. The rationale is to prevent sudden withdrawals that could force the manager to have to unwind positions.

18. With respect to the operations of a hedge fund, a high water mark is designed to:

A)prevent a manager from allowing the fund to become so large that it cannot be managed efficiently and/or use its selected style effectively.
B)prevent a manager from being paid twice for the same gains of the fund.
C)put a cap on the assets-under-management fee.

Explanation: The high-water mark provision is designed to prevent payment to a manager twice for the same gains. If a fund goes from $100 to $120 in value and the manager earns an incentive fee for the $20 gain, and then the fund’s value goes down to $110 and back to $120, the manager will not earn a fee for the gain from $110 back to $120. $120 was a “high water mark.”

19. Which of the following would be among the most common compensation structures for the manager of a hedge fund?

A)An assets-under-management fee of 1.5% and an incentive fee of 20% of the dollar return over the initial investment.
B)An assets-under-management fee of 20% and an incentive fee of 1.5% of the dollar return over the initial investment.
C)An assets-under-management fee of 1.5% and a lock-up fee of 20%

Explanation: The most common compensation structure of a hedge fund consists of an assets-under-management fee, or AUM fee, of about 1%-2% and an incentive fee of 20% of “profits”. The definition of profit should be spelled out in the terms of the investment. It could be dollar return over the initial investment, for example, or the dollar return above the initial investment increased by some hurdle rate

20. William Jones, CFA, has a client who wants to invest in a hedge fund. Jones might recommend a fund of funds instead of a single fund for all of the following reasons EXCEPT a fund of funds:

A)would have a lower correlation with equity markets.
B)would be more liquid.
C)may serve as a better indicator of aggregate performance of hedge funds.

Explanation: Fund of funds are usually considered good choices for individual investors because they offer diversification, usually offer more liquidity, and suffer from less survivorship bias thus they may serve as a better indicator of aggregate performance of hedge funds. One problem with fund of funds is that they are usually more correlated with equity markets than an individual fund, and this lowers their ability to diversify the overall portfolio.

21. Style drift and survivorship bias are often mentioned in the analysis of hedge fund performance. Which of the following statements is most accurate? Fund of funds can serve as better indicators of aggregate hedge fund performance than hedge fund indices because they tend to have a lower level of:

A)both survivorship bias and style drift.
B)survivorship bias only.
C)style drift only.

Explanation: A fund of funds may serve as a better indicator of aggregate performance of hedge funds (i.e., a better benchmark) because they suffer from less survivorship bias. If a fund of funds includes a fund that dissolves, the fund of funds includes the effect of that failure in the return of the fund of funds; however, an index may simply drop the failed fund. A fund of funds can suffer from style drift. This can produce problems in that the investor may not know what he/she is getting. Over time, managers may tilt their respective portfolios in different directions. It is not uncommon that two fund of funds who claim to be of the same style to have returns with a very low correlation.

22. With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of:

A)no reason; fund of funds earn returns that are equal to those of individual hedge funds.
B)both the extra layer of fees and the higher liquidity offered.
C)the extra layer of fees only.

Explanation: Fund of funds are usually considered good choices for individual investors because they offer diversification and usually more liquidity. One problem with fund of funds is that they usually have lower returns. This is a result from both the additional layer of fees and cash drag (resulting from a desire to have higher liquidity)