2019 CFA level 3 qbank reading 30 alternative investments portfolio management answers

Study Session 15, Module 30.2, LOS 30.g Related Material SchweserNotes - Book 4 Question #2 of 87 Which of the following most likely represents the timeline of a private equity fund?. St

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Question #1 of 87

Compared to stocks, direct equity investments in real estate have had:

A) higher volatility of returns.

B) lower volatility of returns.

C) about the same volatility of returns.

Explanation

Lower volatility is the correct answer The average return has actually been lower than those

of stocks over the long-term

(Study Session 15, Module 30.2, LOS 30.g)

Related Material

SchweserNotes - Book 4

Which of the following most likely represents the timeline of a private equity fund?

A) The commitment period of 2 years, the life of the fund reaching 5 years, an option

to extend the fund 3 more years

B) The commitment period of 7-10 years, the life of the fund reaching 12-15 years, an

option to extend the fund 5 more years

C) The commitment period of 5 years, the life of the fund reaching 7-10 years, an

option to extend the fund 5 more years

Explanation

The commitment period usually occurs during the rst ve years when the sponsor gives the

capital calls The expected life of these funds is 7-10 years, and there is often an option to

extend the life up to 5 more years

(Study Session 15, Module 30.3, LOS 30.k)

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With respect to managed futures and real estate, legal issues and valuation methods are

special due diligence issues associated with:

A) real estate only.

B) managed futures only.

C) real estate and managed futures.

Explanation

Active, direct investment in real estate requires all the due diligence checkpoints For the

investment process due diligence checkpoint, valuation methods deserve special attention

Under documents, there may be special zoning and legal issues

(Study Session 15, Module 30.1, LOS 30.d)

In alternative investments, distressed debt arbitrage seeks to earn a return from:

A) an improvement in the prospects of the rm only.

B) either the decline of the stock to zero or an improvement in the prospects of the

rm

C) the decline of the stock to zero only.

Explanation

Distressed debt arbitrage is the purchasing of a company's distressed debt while selling the

equities short The investment can earn a return in two ways: 1) if the equity declines or goes

to zero the investor gains from the short position but may continue to gain from the long

bond position, 2) if the company's prospects improve, because of the seniority of bond

claims, the returns to bond holders should be greater than that of equity holders The

possibility of returns from two events provides a good market opportunity

(Study Session 15, Module 30.6, LOS 30.t)

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In the due diligence process of selecting an active manager of alternative investments,

"assessing the organization of the manager's rm" means assessing the:

A) terms and structure of the investments the manager o ers.

B) stability of the rm and sta turnover.

C) documents (e.g., prospectuses of the investments the manager o ers).

Explanation

Assessing the organization of the manager and his/her operations means assessing whether

it is stable and well run This would also mean measuring the sta turnover

(Study Session 15, Module 30.1, LOS 30.b)

In the due diligence process of selecting an active manager of alternative investments,

"assessing the investment process" means assessing the:

A) stability of the organization and employee turnover.

B) special assets the manager o ers.

C) competitive edge the manager o ers.

Explanation

In the due diligence checkpoints, "assessing the investment process" means assessing the

competitive edge the manager o ers The special assets are associated with the "market

opportunity" checkpoint The stability of the organization and employee turnover is

associated with the "organization" checkpoint

(Study Session 15, Module 30.1, LOS 30.b)

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Which of the following statements regarding how managed futures are typically structured is

C) Commodity pool operators can act as commodity trading advisors who actively

manage a pool of futures contracts

Explanation

Managed futures programs are typically run by Commodity Pool Operators (CPOs) CPOs can

themselves be commodity trading advisors (CTAs) or will hire CTAs to actually manage all or

part of the pool In the United States, both must be registered with the U.S Commodity

Futures Trading Commission and the National Futures Association Some CTAs may choose to

work independently outside of a public or private CPO structure

(Study Session 15, Module 30.5, LOS 30.s)

Compared to common stockholders, investors who use convertible preferred stock to make

venture capital investments will receive the promised dividend:

A) only if common stockholders receive a dividend or a disbursement through

Preferred stockholders must be paid a speci ed amount, say twice the initial investment,

before common stockholders can receive cash in the form of dividends or distributions

through liquidation

(Study Session 15, Module 30.3, LOS 30.j)

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In distressed securities investing, a private equity fund that seeks to partner with the company

in which the fund invests would most likely be called:

A) an orphan equity fund.

B) a high yield fund.

C) a vulture fund.

Explanation

A "vulture fund" is a private equity fund that uses an "active" approach where the fund or

investor acquires positions in the company, and the investment gives some measure of

control The investor can then in uence and assist the company and then acquire more

ownership in the process of any reorganization By providing services and obtaining a

strategic position, the investors create their own opportunity

(Study Session 15, Module 30.6, LOS 30.t)

With respect to weighting schemes for hedge fund indices, the weighting schemes:

A) are always based upon assets under management.

B) can be either equally weighted or based upon assets under management.

C) are always equally weighted.

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In making investments in private equity, diversi cation is:

A) possible by holding a number of positions, but usually only for investors with

portfolios over $100 million

B) possible by holding a number of positions, and the size of the portfolio is not an

issue

C) not possible to any investor.

Explanation

Diversi cation through number of positions can be a problem since commitments are usually

large Usually investors with portfolios well over $100 million can invest in the necessary 5-10

investments needed for diversi cation

(Study Session 15, Module 30.3, LOS 30.l)

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

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

(Study Session 15, Module 30.4, LOS 30.o)

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Special due diligence issues such as valuation, credit analysis, and nancial structure are most

likely associated with investments:

A) in distressed securities.

B) made indirectly in real estate.

C) in managed futures.

Explanation

Distressed securities investing requires due diligence with respect to business valuation,

credit analysis, and assessing the company's problems and nancial structure

In distressed securities investing, the fact that there can be cyclical supply and demand for

these investments is associated with:

A) market liquidity risk.

B) J-factor risk.

C) arbitrage risk.

Explanation

Market liquidity risk refers to the low liquidity and the fact that there can be cyclical supply

and demand for these investments

(Study Session 15, Module 30.6, LOS 30.u)

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Hedge fund managers with good track records:

A) generally continue to have good track records.

B) often demand higher incentive fees.

C) usually lower their fees to increase the assets under management.

Explanation

Managers with good track records often demand higher incentive fees The concern for

investors is whether the manager with a good historical record can continue to perform well

enough to justify the higher fees

A hedge fund that focuses on earning returns from mergers, spin-o s, 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-o s, takeovers, etc For example, if

company X announces it will acquire company Y, the manager might buy shares in Y and

In the structure of a hedge fund, which of the following is least accurate concerning a lock-up

period? A lock-up period:

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A) establishes a cap on new investment.

B) establishes exit windows.

C) establishes a minimum investment period for each investment.

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

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

B) 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

1 Exposure to asset classes that stocks and bonds cannot provide

2 Exposure to special investment strategies such as those used by hedge funds

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

(Study Session 15, Module 30.1, LOS 30.a)

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Direct investment in commodities has become easier for all investors because of the:

A) increased number of hedge funds in these markets.

B) increase in hedging activities of managers in rms that produce and/or deal in

commodities

C) the increase in the number of commodity indices.

Explanation

There has been an increase in the number of indices making it easier for smaller investors to

invest in commodities and take derivative positions in commodities

(Study Session 15, Module 30.5, LOS 30.m)

Which stage of nancing generally supports further expansion of production and sales?

A) The second stage.

B) The third stage.

C) The rst stage.

Explanation

The second stage of nancing supports further expansion of production and sales The third

stage of nancing typically can support additional major expansion First stage funding is

used to begin manufacturing and sales

(Study Session 15, Module 30.3, LOS 30.h)

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A) It uses an arbitrary reference return.

B) It is a stand-alone measure that ignores the diversi cation contributions of a hedge

fund to an overall portfolio

C) It has had little success in predicting winners.

Explanation

The Sharpe ratio is a very standardized measure, and none of the inputs are arbitrary Both

remaining choices are recognized shortcomings of the Sharpe ratio

(Study Session 15, Module 30.4, LOS 30.f)

Compared to indirect investments in commodities, direct investments o er:

A) less exposure to commodity returns but lower carrying costs.

B) more exposure to commodity returns but higher carrying costs.

C) less exposure to commodity returns and higher carrying costs.

Explanation

Often indirect investments via investing in a company producing the commodity provide

lower exposure because the managers hedge the very exposure the investor seeks Direct

investments in commodities incur costs of storage called carrying costs

(Study Session 15, Module 30.5, LOS 30.m)

Frank Campbell, CFA, has a client who wants to make a venture capital investment Campbell is

considering recommending convertible preferred Which of the following is most likely an

advantage of using convertible preferred stock in making an investment in venture capital?

Convertible preferred stock:

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A) bene ts in the event of a company buyout.

B) has dividends that can increase.

C) ranks ahead of debt investors.

Explanation

Convertible preferred stock has a conversion feature that can be exercised if the stock is

purchased at a premium as in a buyout Debt ranks ahead of preferred stock and preferred

dividends are normally xed

(Study Session 15, Module 30.3, LOS 30.j)

With respect to information e ciency and potential for diversi cation, in comparing alternative

investments to exchange traded stocks, the markets for alternative investments are:

A) more informationally e cient and provide more opportunity for diversi cation.

B) less informationally e cient and provide less opportunity for diversi cation.

C) less informationally e cient and provide more opportunity for diversi cation.

Explanation

Alternative investments can provide exposure to unique risks and trading strategies and thus

provide good diversi cation to a stock and bond portfolio The markets for alternative

investments are informationally less e cient than most stock markets

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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) the Hera Fund only.

B) either fund.

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 di erence is

that hedged equity strategies do not focus on balancing the positions to eliminate systematic

With respect to the terms "formative-stage companies" and "expansion-stage companies",

which are considered issuers of venture capital?

A) Formative-stage companies only.

B) Both formative-stage companies and expansion-stage companies.

C) Neither formative-stage companies nor expansion-stage companies.

Explanation

Issuers of venture capital include formative-stage companies that are either new or young

and expansion-stage companies that need funds to expand their revenues or prepare for an

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In the life of a private equity fund, capital calls represent the:

A) request for more capital by the fund sponsor from the investors after the

commitment period

B) request for more capital by the fund sponsor from the investors during the

commitment period

C) request for more capital by the fund sponsor from the investors at the beginning of

the fund prior to the commitment period

Explanation

The timeline includes the sponsor getting commitments from the investors at the start of the

fund and then giving "capital calls" over the rst ve years (typically) called the commitment

period to bring in the promised cash

Jill Tillman, CFA, has a client who wishes to invest in private equity The client's total portfolio is

$2 million The client wants to invest $250,000 in private equity, wants to keep the money

invested for 7-10 years, and does not need liquidity Tillman should:

A) invest the client’s money because private equity has the desired properties.

B) not invest the money because private equity requires a longer holding period than

speci ed by the client

C) not invest the money because it represents too much of the client’s portfolio.

Explanation

Private equity has low liquidity The allocation to this class should be 5% or less with a plan to

keep the money invested for 7-10 years Since the client only has $2 million, the $250,000

(12.5%) requested investment is too large

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Bernice Clark, CFA, is analyzing the portfolio of a private wealth client In the process, Clark

wants to address special issues that alternative investments raise for her client The special

issues would:

A) not include measuring the ownership in the client’s corporate bond portfolio and

not include measuring the client’s ownership in closely held companies

B) not include measuring the ownership in the client’s corporate bond portfolio but

would include measuring the client’s ownership in closely held companies

C) include measuring the ownership in the client’s corporate bond portfolio and the

client’s ownership in closely held companies

Explanation

Special issues that advisors for private-wealth clients should address are tax issues,

determining suitability, communicating with the client, decision risk, and determining if they

have a large position in a closely-held company Measuring the ownership in corporate bonds

is not a "special issue."

(Study Session 15, Module 30.1, LOS 30.c)

Diversi cation is one of the major issues that must be addressed when formulating a private

equity investment strategy To be considered diversi ed, investors must be able to invest in 5

to 10 di erent investments Which of the following statements regarding private equity is most

accurate?

A) Liquidity is usually not an issue with private equity due to its positive correlation

with equities

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B) Smaller portfolios can achieve the necessary diversi cation by investing in private

equity funds

C) The typical private equity investment is usually less than 7 years.

Explanation

Private equity is considered illiquid with the typical commitment being 7 to 10 years Large

portfolios of at least $500 million are needed to invest in 5 to 10 di erent investments

achieving the necessary diversi cation Smaller portfolios can invest in private equity funds

achieving the necessary diversi cation

In contrast to venture capital funds, buyout funds usually have:

A) less frequent losses and less upside potential.

B) less frequent losses and more upside potential.

C) more frequent losses and more upside potential.

Explanation

These di erences are the natural consequence of the buyout funds purchasing entities in

later stages of development or even established companies where the risks are lower

(Study Session 15, Module 30.3, LOS 30.i)

As an investment, the commodity energy is:

A) nonstorable and a hedge against in ation.

B) storable and a hedge against in ation.

C) nonstorable but not a hedge against in ation.

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Commodities that are not agricultural products tend to be storable and hedges against

in ation Energy is both storable and its return has been correlated with in ation

(Study Session 15, Module 30.5, LOS 30.n)

When added to a portfolio of stocks and bonds, based upon historical performance, we can

expect distressed securities to contribute:

A) diversi cation but not enhanced return.

B) enhanced return but not diversi cation.

C) both enhanced return and diversi cation.

Explanation

Distressed securities have provided a relatively high average return but large negative skew

so comparisons using averages and Sharpe ratios or average return-to-volatility ratios can be

misleading The returns are often event-driven so the return is uncorrelated to the overall

stock market and can provide diversi cation

With respect to adding managed futures investing to a stock and bond portfolio:

A) a trend-following strategy will o er lower diversi cation than a contrarian strategy.

B) a trend-following strategy will o er more diversi cation than a contrarian strategy.

C) a trend-following strategy will o er diversi cation equal to that of a contrarian

strategy

Explanation

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For managed futures funds, a trend-following strategy will o er lower diversi cation than a

contrarian strategy This should be obvious since the trends would be those of the cash

markets for which the investor is trying to obtain diversi cation The market for the

underlying securities will also play a role

(Study Session 15, Module 30.1, LOS 30.d)

Commodities can be categorized into storable and nonstorable Which category, if any, should

an analyst recommend as a hedge against in ation?

A) Both storable and nonstorable commodities.

B) Storable commodities.

C) Nonstorable commodities.

Explanation

Storable commodities like energy and metals have returns that are positively correlated with

in ation The positive correlation means the real return will tend to remain positive even

when in ation increases

(Study Session 15, Module 30.5, LOS 30.n)

In contrast to venture capital funds, buyout funds usually have a:

A) higher level of leverage and earlier and steadier cash ows.

B) lower level of leverage and earlier and steadier cash ows.

C) higher level of leverage and later and more erratic cash ows.

Explanation

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Buyout funds are usually investing in later-stage companies where the risks are lower The

cash ows are steadier and the investors can use more leverage

(Study Session 15, Module 30.3, LOS 30.i)

In the special issues that alternative investments raise for investment advisors of private wealth

clients, with respect to tax issues and suitability:

A) both are explicitly special issues to consider.

B) suitability is a special issue to consider but tax issues are not.

C) tax issues are a special issue to consider but suitability is not.

Explanation

Special issues that advisors for private-wealth clients should address are tax issues,

determining suitability, communicating with the client, decision risk, and determining if they

have a large position in a closely-held company

(Study Session 15, Module 30.1, LOS 30.c)

As an asset class, over the period from 1996 to 2015, commodities:

A) enhanced the return of an equally weighted stock and bond portfolio due to

commodities’ low correlation with stocks and bonds

B) underperformed the return of an equally weighted stock and bond portfolio both

on an absolute and risk adjusted basis

C) enhanced the risk adjusted return of an equally weighted stock and bond portfolio

due to commodities’ low correlation with stocks and bond

Explanation

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The results show that over the 1996 to 2015 period studied, when commodities were added

to an equally weighted portfolio of stocks and bonds, commodities underperformed U.S

equity and bond markets both on an absolute and risk adjusted basis Due to the low

correlation of the returns of the S&P GSCI with the S&P 500 (0.25) and negative correlation

with the Bloomberg Barclays U.S Government Bond Index (–0.10), we would expect to see

diversi cation bene ts with improving average return-to-volatility ratios but the results do

not support those conclusions The overall conclusion in the CFA text is that commodities

o er diversi cation bene ts due to their low correlation with stocks and slightly negative

correlation and bonds even though the results of the time period studied suggests otherwise

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 a lock-up fee of 20%.

B) An assets-under-management fee of 1.5% and an incentive fee of 20% of the dollar

return over the initial investment

C) An assets-under-management fee of 20% and an incentive fee of 1.5% of the dollar

return over the initial investment

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 "pro ts" The

de nition of pro t 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

(Study Session 15, Module 30.4, LOS 30.p)

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The structure, explanation of performance data, and style and strategy are special due

diligence issues most associated with:

A) distressed securities.

B) hedge funds.

C) direct real estate investing.

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

With respect to due diligence costs and liquidity, in comparing alternative investments to

exchange traded stocks, the markets for alternative investments have:

A) more liquidity and higher due diligence costs.

B) less liquidity and lower due diligence costs.

C) less liquidity and higher due diligence costs.

Explanation

The common features are: low liquidity, provide good diversi cation, due diligence costs are

high, di cult appraisals, and the markets for alternative investments are informationally less

e cient than most stock markets

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A) prevent a manager from allowing the fund to become so large that it cannot be

managed e ciently and/or use its selected style e ectively

B) put a cap on the assets-under-management fee.

C) prevent a manager from being paid twice for the same gains of the fund.

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."

(Study Session 15, Module 30.4, LOS 30.p)

If a hedge fund goal is the elimination of systematic risk, a problem for the fund in motivating

the manager is that:

A) the standard incentive fee only applies to assets under management and would not

reward the elimination of systematic risk

B) it is impossible to gauge the degree to which systematic risk has been eliminated.

C) the standard incentive fee only applies to raw earnings and would not reward the

elimination of systematic risk

Explanation

There is some controversy concerning fees because a manager may have or should have

other goals than simply earning a gross return For example, the manager may/should be

providing limited downside risk and diversi cation The basic incentive fee does not reward

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When evaluating the performance of a hedge fund that uses leverage, the convention is to:

A) not attempt to evaluate the fund because the existence of leverage makes such an

assessment impossible

B) treat an asset as if it were fully paid to e ectively “look through” the leverage.

C) use an optimization model to determine the weights on the book and debt values.

Explanation

The conventions for dealing with leverage is to treat an asset as if it were fully paid to

e ectively "look through" the leverage When derivatives are included, the same principle of

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) may serve as a better indicator of aggregate performance of hedge funds.

B) would be more liquid.

C) would have a lower correlation with equity markets.

Explanation

Fund of funds are usually considered good choices for individual investors because they o er

diversi cation, usually o er more liquidity, and su er 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

(Study Session 15, Module 30.4, LOS 30.q)

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