CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 09 alternative investments answers

Sample Scoring Key: 1 point each for explaining each term and 2 points for explaining how and why it biases reported returns upward.. Infrequent appraisal data leads to less volatile pr

ALTERNATIVE INVESTMENTS

Answers

Question 1

Part A

Advantages:

1 Earlier and steadier cash flows

2 Less frequent losses

3 Less error in the measurement of returns

4 The potential for using higher leverage

Disadvantage: less upside potential than venture capital

Sample Scoring Key:

1 point each for two advantages and one disadvantage

Part B

Comment

Is the comment correct?

(circle one)

Explanation

"Private equity is more of a

diversifier than a long-term

return enhancer."

Yes

No

The high correlation to equity reduces any portfolio diversification benefit

"There is also the carried

interest, which is interest

limited partners have to pay

to cover the financing costs

of leverage."

Yes

No

Carried interest is the share of the profits that is paid to the manager

“You should use real estate

investments in raw land

rather than buyout funds to

generate more immediate

cash flow.”

Yes

No

Raw land generally provides no cash flow

Buyout funds may generate income in excess of financing costs and provide a more immediate cash flow to investors

“I want to make sure that the

preferred is structured so that

later investors can receive

seniority in order to increase

their claim on the company

assets.”

Yes

No

Subsequent rounds of convertible preferred are generally issued senior to the earlier rounds, reducing the early investors’ claim on company assets

Sample Scoring Key:

1 point each for correctly identifying whether the comment is correct

1 point for each explanation

0 points if yes/no decision is incorrect

Question 2

Part A

Backfill bias—managers who build a successful track record then begin to report results and the past successful returns are then added to the index, biasing returns upward

Survivorship bias—the past record of a fund that goes out of business is removed from the index These funds are more likely to have a poor record, biasing upward the reported return record

Only the surviving funds are reported

Sample Scoring Key:

1 point each for explaining each term and 2 points for explaining how and why it biases reported returns upward

Part B

i Illiquidity leads to a lack of trading and the use of appraisal data for prices Infrequent

appraisal data leads to less volatile prices and distorts downward reported standard deviation used in the denominator of the Sharpe ratio, biasing the Sharpe ratio upward

ii A manager can increase reported return by compounding sub period return used in the

numerator of the Sharpe ratio while reducing the related reported standard deviation used in the denominator by using multiplicative annualization The combined result is to increase the Sharpe ratio

Sample Scoring Key:

3 points for each explanation For full credit, the explanation must describe numerator and/or denominator issues

Question 3

Part A

Significant diversification: True All three classes have low correlation to traditional stock and bond portfolios, providing significant diversification

Sufficient liquidity:

 False Real estate is not a regularly traded asset, and even if MWM does monthly valuation, the underlying assets lack liquidity

 True Commodity positions are generally taken with liquid derivative positions

 True Managed futures typically use exchange traded derivative positions, and those are liquid

o (Alternative answer and explanation: False Managed futures can be a subset of hedge funds, and the manger may be using illiquid positions and strategies that cannot be unwound.)

Sample Scoring Key:

One point each for: each asset class with a correct explanation of most likely true or false There are three asset classes and two features to discuss, for six points in total

Candidate discussion: Explain implies you will receive no credit for only saying true or false

Low correlation and liquidity of the underlying assets are the driving factors to the explanations Managed futures reflect manager skill and are not considered an asset class with inherent

characteristics We don’t know the strategies used, allowing true or false for liquidity if properly explained

Part B

Manager strategy: Slide 3 indicates MWM is using commodities in a managed futures approach

of selectively taking long positions in backwardation markets and short positions in contango markets to earn positive roll She is not just long commodities to gain asset class exposure

Sample Scoring Key:

One point for “manager strategy.” Three points for the explanation

Candidate discussion: The key is that MWM targets value added in both downward

(backwardation) and upward-sloping (contango) markets In other words, the manager takes long and short positions This is not long-only (commodity as an asset class) investing but a managed futures strategy applied to the commodity market Simply stating MWM takes both long and short positions earns one of the three explanation points That statement alone is weak (in a 4-point question) when you had the information and training to elaborate You should convey to the grader how you know and support the decision Describing the manager strategy to earn positive roll return in both types of markets would be a convincing way to do so You could mention the slide states they are active cash managers but should not expect any credit Simply being an active manager is not the issue The issue is that the slide indicates both long and short positions are used, so there can be no inherent asset class characteristics (In contrast, long-only positions

in commodity futures provide the inherent asset class characteristics of commodities.)

Part C

Advantages:

 It represents investable securities

 It represents liquid investments

 It is not subject to appraisals and smoothing problems

Disadvantages:

 It reflects blended characteristics of RE and equity

 It reflects leveraged and over-stated return results

Sample Scoring Key:

One point for each advantage listing two and one point for each disadvantage listing two The question is based on knowing how NAREIT and NCREIF indexes differ and match up with evaluating a manager who purchases RE properties