cfa level - 1...2018/09/28 · cfa level - 1 alternative investment page 8 solution b is correct....

CFA LEVEL - 1 ALTERNATIVE INVESTMENT

Page 1

A. Compare alternative investments with traditional investments

QUESTIONS 1

Compared to traditional investments, alternative investments least likely demonstrate which ofthe following characteristics?

A. Narrow manager specializationB. Underlying investments that are illiquidC. A high degree of regulation


Page 2

Solution

C is correct.

Alternative investments are less regulated and transparent than traditional investments suchas equity and debt securities.

A is incorrect because narrow manager specialization is a characteristic of alternativeinvestments.

B is incorrect because a characteristic of alternative investments is that the underlyinginvestments are illiquid.


Page 3

A.Compare alternative investments with traditional investments

QUESTIONS 2

Relative to traditional investments, alternative investments are most likely to be characterizedby higher:

A. fees.B. liquidity.C. transparency.


Page 4

Solution

A is correct.

Alternative investments are often characterized by high fees.

B is incorrect because liquidity tends to be comparably low in alternative investments.

C is incorrect because transparency tends to be comparably low in alternative investments.


Page 5

A.Compare alternative investments with traditional investments

QUESTIONS 3

Compared with long-only investments in stocks and bonds, alternative investments are mostlikely characterized by less:

A. flexibility to use derivatives.B. manager specialization.C. transparency.


Page 6

Solution

C is correct.

Alternative investments are typically expected to have a lower level of regulation and lesstransparency than traditional long-only investments. A is incorrect because alternativeinvestments typically give the manager more flexibility to use derivatives and leverage, investin illiquid assets, and take short positions, as compared with traditional investments.

B is incorrect because alternative investments are often characterized by narrow managerspecialization, as compared with traditional long-only investments.


Page 7

A.Compare alternative investments with traditional investmentsC. Describe potential benefits of alternative investments in the context of portfoliomanagement

QUESTIONS 4

A least likely reason for investors to include commodity derivatives in their investmentportfolios is:

A. commodity-related stocks’ positive correlation with the overall equity market.B. it eliminates the need to understand the physical supply chain and general supply–

demand dynamics of a commodity.C. the tendency for commodity prices to be positively correlated with inflation.


Page 8

Solution

B is correct.

Because the prices of commodity derivatives are, to a significant extent, a function of theunderlying commodity prices, it is important to understand the physical supply chain andgeneral supply–demand dynamics of a commodity.

A is incorrect because commodity-related stocks tend to exhibit a high degree of correlationwith the overall equity market. High correlation means low diversification benefits, whichreduces the appeal of including this type of investment in a portfolio so investors may bedrawn to commodity derivatives that have a lower correlation with the overall equity market.

C is incorrect because commodity prices tend to be positively correlated with inflation.


Page 9

B. Describe categories of alternative investments

QUESTIONS 5

Categories of alternative investments would least likely be described by which of thefollowing?

A. Fine wine and other tangiblesB. Schools and other long-lived real assetsC. Cash and other liquid investments


Page 10

Solution

C is correct.

Cash and other short-term liquid investments would not generally be considered alternativeinvestments. Alternative investments fall outside of the definition of long-only publicly tradedinvestments in stocks, bonds, and cash (often referred to as traditional investments). In otherwords, these investments are alternatives to long-only positions in stocks, bonds, and cash.

A is incorrect because the category “collectibles” would include tangible assets such as finewine, art, antique furniture, and automobiles.

B is incorrect because the category “infrastructure” would include capital intensive, long-lived,real assets, such as roads, dams, and schools.


Page 11


QUESTIONS 6

Capital provided for companies moving toward operation but before commercialmanufacturing and sales have occurred best describes which stage in venture capital investing?

A. Later stageB. Seed stageC. Early stage


Page 12

Solution

C is correct.

Early-stage financing is capital provided for companies moving toward operation but beforecommercial manufacturing and sales have occurred.

A is incorrect because later-stage financing is provided after commercial manufacturing andsales have begun but before any initial public offering.

B is incorrect because seed-stage financing is capital provided for a business idea.


Page 13


QUESTIONS 7

The majority of private equity activity involves:

A. derivative positions.B. leveraged buyouts.C. investing in mortgaged-backed securities.


Page 14

Solution

B is correct.

The majority of private equity fund activity involves leveraged buyouts of established profitableand cash generative companies.

A is incorrect because although a private equity fund may use derivatives, this use is not adefining characteristic of private equity investing. Derivative strategies are most likely used inhedge fund and commodity investment strategies.

C is incorrect because private equity funds generally invest in non-publicly traded companies orpublic companies with the intent to take them private, not mortgage-backed securities whichare a form of publicly traded real estate debt.


Page 15


QUESTIONS 8

Hedge funds are least likely to have restrictions concerning:

A. the withdrawal of invested funds.B. the use of derivatives.C. the number of investors in the fund.


Page 16

Solution

B is correct.

The use of derivatives is a typical feature of contemporary hedge funds.

A is incorrect because hedge funds tend to impose restrictions on the withdrawal of funds.

C is incorrect because investing in hedge funds is open only to a limited number of investors.


Page 17


QUESTIONS 9

Which of the following least likely describes an advantage of investing in hedge funds througha fund of funds? A fund of funds may provide investors with:

A. access to due diligence expertise.B. lower fees because of economies of scale.C. access to managers who can negotiate better redemption terms.


Page 18

Solution

B is correct.

The fees on funds of funds are usually higher. The fund of funds manager charges a fee, andthere is a fee charged by each hedge fund.

A is incorrect because this is an advantage of investing through funds of funds.

C is incorrect because this is an advantage of investing through funds of funds.


Page 19


QUESTIONS 10

An alternative investments fund that uses leverage and takes long and short positions insecurities is most likely a:

A. leveraged buyout fund.B. hedge fund.C. venture capital fund.


Page 20

Solution

B is correct.Hedge funds invest in securities and may take long and short positions. They may also useleverage.

A is incorrect because Leveraged buyout funds make equity investments in establishedcompanies.

C is incorrect because Venture capital funds provide capital to start-up firms with high growthpotential.


Page 21

C. Describe potential benefits of alternative investments in the context of portfoliomanagement

QUESTIONS 11

If the level of broad inflation indexes is largely determined by commodity prices, the averagereal yield on direct commodity investments is most likely:

A. less than zero.B. equal to zero.C. greater than zero.


Page 22

Solution

B is correct.

As the price increases of commodities are mirrored in higher price indexes, the nominal returnis equal to inflation and thus the real return is zero.

A is incorrect because a negative real return implies inflation greater than nominal return. Thisis not the case if commodity price increases determine inflation.

C is incorrect because a positive real return implies inflation less than nominal return. This isnot the case if commodity price increases determine inflation.


Page 23

C. Describe potential benefits of alternative investments in the context of portfoliomanagement

QUESTIONS 12

Based on the historical record, adding alternative investments to a traditional investmentportfolio consisting of publicly traded debt and equity will most likely decrease the portfolio’s:

A. liquidity.B. downside risk.C. risk-adjusted return.


Page 24

Solution

A is correct.

Many categories of alternative assets have low liquidity because of the fund structures used(e.g., limited partnerships for hedge funds and private equity) or high transactions costs forunderlying assets (e.g., real estate). Alternative assets have generally had high downside risks.However, low correlations with traditional asset classes suggest strong diversifying potential,and high returns result in relatively strong Sharpe ratios (high risk-adjusted returns).

B is incorrect because many alternative investments have exhibited high downside risks.

C is incorrect because many alternative investments have exhibited strong risk-adjustedreturns and low correlations with traditional asset classes.


Page 25

E. Describe, calculate, and interpret management and incentive fees and net-of-fees returnsto hedge funds

QUESTIONS 13

When the futures price of a commodity exceeds the spot price, the commodity market is mostlikely in:

A. contango.B. backwardation.C. carry.


Page 26

Solution

A is correct.

When a commodity market is in contango, futures prices are higher than spot prices. Whenspot prices are higher than the futures price, the market is said to be in backwardation.

B is incorrect because backwardation is the opposite of contango; the futures price is belowthe spot price.

C is incorrect because carry refers to storage plus interest costs. It does not say anything aboutfutures prices relative to spot prices.


Page 27

D. Describe hedge funds, private equity, real estate, commodities, infrastructure, and otheralternative investments, including, as applicable, strategies, sub-categories, potentialbenefits and risks, fee structures, and due diligence

QUESTIONS 14

With regard to venture capital, which of the following statements is most likely true regardingventure capital?

A. Investments typically are in later stage and more established companies.B. Investors tend to have short time horizons.C. Investors require a higher return than investors in publicly traded equity.


Page 28

Solution

C is correct.

The historical standard deviations of annual return for venture capital are higher than that ofcommon stocks. Investors should therefore require a higher return in exchange for acceptingthis higher risk, along with the illiquidity of venture capital investing.

A is incorrect because the venture capital strategy typically invests in start-up or early stagecompanies, not later stage companies.

B is incorrect because venture capital investments require long time horizons.


Page 29


QUESTIONS 15

A real estate investor looking for equity exposure in the public market is most likely to investin:

A. real estate limited partnerships.B. shares of real estate investment trusts.C. collateralized mortgage obligations.


Page 30

Solution

B is correct.

Shares in real estate investment trusts are publicly traded and represent an equity investmentin real estate.

A is incorrect because real estate limited partnerships are an example of a private real estateinvestment.

C is incorrect because a collateralized mortgage obligation is an example of debt-basedexposure to real estate.


Page 31


QUESTIONS 16

Which of the following characteristics of a target company is likely the least attractive for aleveraged buyout?

A. Substantial amount of physical assetsB. Strong and sustainable cash flowC. High leverage


Page 32

Solution

C is correct.

Low leverage is an attractive feature of a target company in a leveraged buyout. Thischaracteristic makes it easier for an acquirer to use debt to finance a large portion of thepurchase price.

A is incorrect because a substantial amount of physical assets is a desirable feature of a targetcompany in a leveraged buyout.

B is incorrect because a strong and sustainable cash flow is a desirable feature of a targetcompany in a leveraged buyout.


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QUESTIONS 17

A manager is compensated with a management fee based on committed capital plus anincentive fee based on fund performance. This scenario best describes the fee structure of a:

A. private equity fund.B. hedge fund.C. mutual fund.


Page 34

Solution

A is correct.

A private equity manager is compensated through a management fee based on committedcapital plus an incentive fee.

B is incorrect because the management fee of a hedge fund is based on assets undermanagement.

C is incorrect because the fee structure for mutual funds usually includes only a managementfee, not an incentive fee.


Page 35


QUESTIONS 18

One hedge fund strategy that involves simultaneously holding short and long positions incommon stock is most likely:

A. volatility.B. distressed/restructuring.C. quantitative directional.


Page 36

Solution

C is correct.

Quantitative directional is an equity strategy that uses technical analysis to identify over- andunderpriced securities, buy the underpriced ones, and short the overpriced ones.

A is incorrect because volatility is a relative value strategy that uses options to profit based onexpectations that market volatility will rise or fall.

B is incorrect because distressed/restructuring is an event-driven strategy that focusesprimarily on fixed-income securities, although it may buy preferred stock and short commonstock of a company.


Page 37


QUESTIONS 19

A private equity firm sells a portfolio company to a buyer that is active in the same industry asthe portfolio company. This transaction is best described as a(n):

A. trade sale.B. secondary sale.C. initial public offering.


Page 38

Solution

A is correct. A trade sale is the sale of a portfolio company to a strategic buyer, such as acompany that is active in the same industry.

B is incorrect because a secondary sale is a sale to another private equity firm.

C is incorrect because an initial public offering involves the sale of shares to public investors.


Page 39


QUESTIONS 20

A private equity limited partner would least likely experience which of the following?

A. Capital calls in the partnership’s early years to fund investments.B. A management fee based on committed capital, not invested capital.C. Short time lags between investments in and exits from portfolio companies.


Page 40

Solution

C is correct.

There are likely to be long time lags between investments in and exits from portfoliocompanies.

A is incorrect because capital calls are likely in the partnership’s early years in order to fundinvestments in new portfolio companies.

B is incorrect because in most private equity firms the general partner earns management feesbased on committed capital, not invested capital.


Page 41


QUESTIONS 21

With regard to commodities, it is most likely true that:

A. exposure is most commonly achieved via commodity derivatives.B. their returns are based on an income stream such as interest or dividends.C. they are physical products so most investors prefer to trade the actual commodity.


Page 42

Solution

A is correct.Commodity exposure is most commonly accessed via commodity derivatives.

B is incorrect because commodities returns are based on changes in price rather than incomestreams.

C is incorrect because holding commodities (i.e., the physical products) incurs costs fortransportation and storage. Thus, most commodity investors do not trade actual physicalcommodities, but rather trade commodity derivatives.


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QUESTIONS 22

An argument for investing in commodities is that they:

A. may provide a hedge against inflation.B. are correlated negatively with stocks and bonds.C. have low volatility.


Page 44

Solution

A is correct.

Given that commodity prices are positively correlated with inflation, commodity investing mayprovide higher returns when inflation is rising. In this way, commodity investing can provideinflation protection.

B is incorrect because commodity prices over decades have been shown to have small andpositive correlation with global stocks and bonds.

C is incorrect because commodity investments, especially when combined with leverage,exhibit high volatility.


Page 45


QUESTIONS 23

A characteristic that makes a target company attractive for a leveraged buyouttransaction most likelyis:

A. efficient management.B. high leverage.C. strong cash flow.


Page 46

Solution

C is correct.

Companies generating strong and sustainable cash flow are attractive for leveraged buyouttransactions because these transactions are typically financed with significant debt where cashflow is necessary to make interest payments on the increased debt load.

A is incorrect because in a leveraged buyout transaction, private equity firms seek to generateattractive returns on equity by creating value in the companies they buy. They achieve this goalby identifying companies that are inefficiently managed and that have the potential to performwell if managed better.

B is incorrect because private equity firms target companies with low leverage in a leveragedbuyout transaction, making it easier to use debt to finance the transaction.


Page 47

D.Describe hedge funds, private equity, real estate, commodities, infrastructure, and otheralternative investments, including, as applicable, strategies, sub-categories, potentialbenefits and risks, fee structures, and due diligence

QUESTIONS 24

An investor seeking an indirect debt investment in real estate will:

A. purchase a mortgage-backed security.B. purchase a commercial property.C. originate a residential mortgage.


Page 48

Solution

A is correct.

Mortgage-backed securities are pools of loans that are securitized and offered to the financialmarkets providing indirect debt investment opportunities in residential property.

B is incorrect because commercial property is considered an appropriate direct investment—equity (i.e., ownership) and debt (i.e. lender)—for institutional or high-net-worth investorswith long time horizons and limited liquidity needs.

C is incorrect because originators (generally financial institutions) of residential mortgages aremaking a direct debt investment in the home.


Page 49


QUESTIONS 25

Which of the following is most likely a private equity strategy?

A. Merger arbitrageB. Venture capitalC. Quantitative directional


Page 50

Solution

B is correct.

Venture capital is a private equity strategy in which private equity companies invest and getactively involved in the management of portfolio companies.

A is incorrect because this is a hedge fund strategy.

C is incorrect because this is a hedge fund strategy.


Page 51


QUESTIONS 26

Compared with other investment asset classes, an investment in real estate is least likely to becharacterized by:

A. homogeneity.B. fixed location.C. basic indivisibility.


Page 52

Solution

A is correct

Because no two properties are identical, homogeneity is not a feature of an investment in realestate.

B is incorrect because a fixed location is an attribute of a real estate investment.

C is incorrect because basic indivisibility is a unique feature of real estate investing.


Page 53


QUESTIONS 27

Illiquidity is most likely a major concern when investing in:

A. real estate investment trusts.B. private equity.C. commodities.


Page 54

Solution

B is correct.

Once a commitment in a private equity fund has been made, the investor has very limitedliquidity options.

A is incorrect because real estate investment trusts are publicly listed, so liquidity is not amajor concern.

C is incorrect because the majority of commodity investments are implemented throughderivatives, so liquidity is not a major concern.


Page 55


QUESTIONS 28

Which attribute would a private equity firm most likely desire when deciding if a company isparticularly attractive as a leveraged buyout target?

A. Sustainable cash flowB. Efficient managementC. Market value exceeds intrinsic value


Page 56

Solution

A is correct.

Private equity firms look for companies that have strong cash flows and a significant amount ofphysical assets. These physical assets can be used as security and borrowed against.

B is incorrect because private equity firms look for companies that are inefficiently managed.The goal is to turn them around and thus perform better.

C is incorrect because private equity firms look for companies that have an intrinsic value thatexceeds their market value.


Page 57


QUESTIONS 29

Which of the following statements concerning the historical record of alternative investmentsis most likely correct?

A. The exclusion of returns of funds that have been liquidated leads to an upward bias inindex performance.

B. The use of appraised values instead of market prices leads to an upward bias in volatility.C. The inclusion of previous return data for funds that enter the index leads to a downward

bias in index performance.


Page 58

Solution

A is correct.

The exclusion of returns of funds that have been liquidated is called survivorship bias. It is mostlikely that only poor performers are eliminated and thus reported returns are artificiallyinflated.

B is incorrect because the use of appraised values instead of market prices leads to adownward bias in volatility.

C is incorrect because the inclusion of previous return data for funds that enter the index iscalled backfill bias. It leads to an upward bias in index performance.


Page 59


QUESTIONS 30

Commodity futures prices are most likely in backwardation when:

A. interest rates are high.B. storage costs are high.C. the convenience yield is high.


Page 60

Solution

C is correct.

In backwardation, futures prices are lower than spot prices, that is, the commodity forwardcurve is downward sloping. This scenario occurs when the convenience yield is high. Futuresprice ≈ Spot price (1 + r) + Storage costs − Convenience yield.

A is incorrect because futures price ≈ Spot price (1 + r) + Storage costs − Convenience yield.Thus, high interest rates contribute to an upward sloping commodity forward curve.

B is incorrect because futures price ≈ Spot price (1 + r) + Storage costs − Convenience yield.Thus, high storage costs contribute to an upward sloping commodity forward curve.


Page 61


QUESTIONS 31

A commodity market is in contango when futures prices are:

A. lower than the spot priceB. the same as the spot price.C. higher than the spot price.


Page 62

Solution

C is correct.

When a commodity market is in contango, futures prices are higher than the spot price.

A is incorrect because this is the definition of backwardation.

B is incorrect because this is neither contango nor backwardation.


Page 63


QUESTIONS 32

The market approach to valuing portfolio companies in private equity firms is most likely basedon:

A. present value.B. the value of assets minus the value of liabilities.C. multiples.


Page 64

Solution

C is correct.

The market approach to valuing portfolio companies uses multiples of different measures thatare compared with similar companies.

A is incorrect because present value is calculated in the context of discounted cash flowmodels.

B is incorrect because the value of assets minus the value of liabilities is calculated in thecontext of asset-based models.


Page 65


QUESTIONS 33

At the first of the year, an investor decides to invest $1.5 million in a hedge fund with anincentive fee of 15% and a hard hurdle rate of 4%. At the end of the year, the fund has a returnof 23.3%. The incentive fee payment that the general partner of the fund earned based on thisclient’s investment at the end of the year is closest to?

A. $43,425B. $52,425C. $38,445


Page 66

Solution

A is correct.

The investor’s return met the 4% hurdle rate, so the incentive fee charged would be($1,849,500 − $1,500,000 − $60,000) × 15% = $43,425.

B is incorrect because the fee was calculated using an increased asset base as follows: 23.3% ×$1.5 million = $349,500 and then taking a 15% incentive fee on this return: $349,500 ×15% =$52,425.

C is incorrect because the fee was calculated using an increased investor asset base as follows:23.3% × $1.5 million = $349,500 and then taking a 15% incentive fee on this return less a 4%hurdle rate: $349,500 × 15% − 4% = $38,445.


Page 67


QUESTIONS 34

A disadvantage of a fund of hedge funds as compared to a large multi-strategy fund is:

A. due diligence expertise.B. higher management fees.C. diversified exposure to various hedge fund strategies.


Page 68

Solution

B is correct.

Funds of hedge funds will add an extra layer of fees because each hedge fund in which suchfund of hedge funds invests will charge a management fee plus an incentive fee. Such a layer offees comes on top of the fees that the fund of hedge funds charges investors., includingmanagement fees, to the costs for investors.

A is incorrect because due diligence expertise is one of the advantages that funds of hedgefunds may offer but multi-strategy funds do not.

C is incorrect because a large multi-strategy fund can also provide a diversification over varioushedge fund strategies.


Page 69


QUESTIONS 35

An investor allocates $10 million at the beginning of the year to a hedge fund charging amanagement fee of 2% and an incentive fee of 20% with a 6% (hard) hurdle rate. At year-endthe value of the investment is $11.8 million. The incentive fee is calculated net of themanagement fee and the management fee is based on the year-end value. The net-of-feesreturn the investor earned is closest to:

A. 13.71%.B. 13.24%.C. 13.93%.


Page 70

Solution

A is correct.

The net-of-fees return to the investor at year-end is closest to 13.71%.

Portfolio gain = Year-end value − Beginning value= $11.8 million − $10 million= $1.8 million

Hurdle amount = Beginning value × Hurdle%= $10 million × 6%= $600,000

Management fee = Year-end value × Management fee %= $11.8 million × 2%= $236,000

Incentive fee Incentive fee = (Portfolio gain − Hurdle amount − Management fee) ×Incentive fee%


Page 71

= ($1.8 million − $600,000 − $236,000) × 20%= $192,800

Total fees = Management fee + Incentive fee= $236,000 + $192,800= $428,800

Net-of-fees return =Portfolio gain Total fees

Beginning( )

value

=18 428 800

10$ . million $ ,

$ mil( )

lion= 13.71%

B is incorrect because 13.24% results from calculating the incentive fee independently from themanagement fee as opposed to net of the management fee:



Page 72

Hurdle amount = Beginning value × Hurdle%= $10 million × 6%= $600,000

Management fee = Year-end value × Management fee%= $11.8 million × 2%= $236,000

Incentive fee Incentive fee = (Portfolio gain − Hurdle amount) × Incen ve fee%= ($1.8 million − $600,000) × 20%= $240,000



Page 73


Beginning( )

value

=1 8 476 000

10$ . million $ ,

$ mil( )

lion= 13.24%

C is incorrect because 13.93% results from calculating the hurdle amount based on the end-of-period value instead of the beginning-of-period value:


Hurdle amount = Ending value × Hurdle%= $11.8 million × 6%= $708,000

Management fee = Year-end value × Management fee%= $11.8 million × 2%= $236,000


Page 74

Incentive fee = (Portfolio gain − Hurdle amount − Management fee) × Incen ve fee%= ($1.8 million − $708,000 − 236,000) × 20%= $171,200



Beginning( )

value

=1 8 407 200

10$ . million $ ,

$ mil( )

lion= 13.93%


Page 75


QUESTIONS 36

A hedge fund with $98 million of initial capital charges a management fee of 2% and anincentive fee of 20%. The management fee is based on assets under management at year endand the incentive fee is calculated independently from the management fee. The fee structurehas a high-water mark provision. The fund value is $112 million at the end of Year 1, $100million at the end of Year 2, and $116 million at the end of Year 3. The net-of-fees returnearned by the fund in Year 3 is closest to:

A. 14.15%.B. 12.33%.C. 11.87%.


Page 76

Solution

A is correct.

The net-of-fees return to the fund in Year 3 is closest to 14.15%, calculated as follows:

Year 1:

Portfolio gain = Year-end value − Beginning value = $112 million − $98 million = $14million

Management fee = Year-end value × Management fee % = $112 million × 2% = $2.24million

Incentive fee = Portfolio gain × Incentive fee % = $14 million × 20% = $2.8 million

Total fees = Management fee + Incentive fee = $2.24 million + $2.8 million = $5.04million

Ending CapitalPosition = Year-end value − Total fees

= $112 million − $5.04 million = $106.96 millionHigh water mark = Ending capital position = $106.96 million


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Year 2:

No incentive fee is earned as the fund declines in value; the high water mark established inYear 1 is not exceeded.

Management fee = Year-end value × Management fee % = $100 million × 2% = $2 millionEnding Capital Position = Year-end value − Management fee

= $100 million − $2 million = $98 millionHigh water mark = Highest ending capital position = $106.96 million

Year 3:

Net-of-fee returns are affected by the Year 1 high water mark and the Year 2 net capitalposition (i.e. Year 3 beginning capital position).

Managementfee = Year-end value × Management fee % = $116 million × 2% = $2.32 million

= ($116 million − $106.96 million) × 20% = $1.81 million.



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Net-of-fees return:

= (Year-end value − Total fees − Beginning capital posi on)/Beginning capital posi on

= ($116 million − $4.13 million − $98 million)/$98 million = 14.15%.

B is incorrect because 12.33% results from calculating the incentive fee using the net capitalposition at the end of Year 2 instead of the high-water mark value established at the end ofYear 1.


Incentive fee = (Year-end value − Year 2 Ending capital position) × Incentive fee%= ($116 million − $98 million) × 20% = $3.60 million.


Net-of-fees return:




Page 79

C is incorrect because 11.87% results from calculating the return based on a Year 2 endingcapital position (i.e., Year 3 beginning capital position) of $100 million. Instead, the returnshould be calculated based on the Year 2 ending capital position of $98 million, which is net offees ($100 million − $2 million).


Incentive fee = (Year-end value − High water mark) × Incen ve fee%= ($116 million − $106.96 million) × 20% = $1.81 million.


Net-of-fees return:




Page 80


QUESTIONS 37

A hedge fund limited partnership agreement describes the general partner’s total fees for eachyear as follows: The general partner will measure the fair value of the fund’s assets at thebeginning of the year (net of fees from the previous year) and the fair value of the fund’s assetsat the end of the year. The general partner will receive 15% of any increase in fair value inexcess of the 1-year US Treasury yield at the beginning of the year. This fee structure mostlikely includes a:

A. hard hurdle rate.B. management fee.C. high-water mark provision.


Page 81

Solution

A is correct.

In order for the general partner to earn its incentive fee, the return on the fund must exceedthe Treasury yield (which is a hurdle rate), and the incentive fee is based only on the return inexcess of the hurdle rate, so it is a hard hurdle rate. The general partner doesn’t earn any feeregardless of performance, so there is no management fee. There is no mention of the fund’svalue needing to exceed its historical maximum value, so there is no high-water mark.

B is incorrect because there is no fixed management fee (one that does not depend onperformance).

C is incorrect because there is no requirement that the fund’s value exceed its previousmaximum.


Page 82


QUESTIONS 38

If the price of a commodity futures contract is below the spot price, it is most likely that the:

A. cost of carry exceeds the convenience yield.B. roll yield is negative.C. convenience yield exceeds storage costs.


Page 83

Solution

C is correct.

The convenience yield must exceed the cost of carry to arrive at a futures price below the spotprice because the futures price is approximately equal to the spot price [(1 + r) + Storage cost −Convenience yield] and the cost of carry is defined as interest cost plus storage cost. Given thatinterest cost is always positive, the convenience yield must also exceed storage costs to arriveat a futures price below the spot price.

A is incorrect because if the cost of carry exceeds the convenience yield, the futures price isabove the spot price.

B is incorrect because roll yield is defined as the difference between the spot price and theprice of the futures contract. If the price of a commodity futures contract is below the spotprice, roll yield is positive.


Page 84


QUESTIONS 39

The three main sources of return for commodities futures contracts most likely are:

A. convenience yield, dividend yield, and spot price return.B. collateral yield, roll yield, and spot price return.C. collateral yield, convenience yield, and roll yield.


Page 85

Solution

B is correct.

The three main sources of return for a commodities futures contract are collateral yield, rollyield, and spot price return.

A is incorrect because collateral yield and roll yield are missing. Dividend yield is not a source ofreturn for commodities futures investments.

C is incorrect because spot price return is missing. A high convenience yield results in asituation where the futures price will be below the spot price. In this case, the price of thefutures contract rolls up to the spot price as the expiry date of the contract approaches.


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F. Describe issues in valuing and calculating returns on hedge funds, private equity, realestate, commodities, and infrastructure

QUESTIONS 40

Initial investment capital $100 million

Return at the end of one year 12%

Management fee based on assetsunder management

1%

Incentive fee based on the returnnet of the management fee

10%

Assume management fees are calculated using end-of-period valuation. The investor’s netreturn given this fee structure is closest to:

A. 10.88%.B. 9.79%.C. 9.68%.


Page 87

Solution

B is correct.

Management fee: 1% of $112 million = $1.12 million

Incentive fee: 10% of ($12 million − $ 1.12 million) = $1.088 million

Fund value after fees: $112 million − $1.12 million − $1.088 million = $109.792 million

Investor return: 109 79210

1 9 790

$ . million$ m lion

.il

%

C is incorrect because it ignores the fact that the incentive fee is calculated net of managementfees. Management fee: 1% of $112 million = $1.12 million.

Incentive fee: 10% of $12 million = $1.2 million.

Fund value after fees: $112 million − $1.12 million − $1.2 million = $109.68 million

Investor return: 109 68100

1 9 68

$ . million$ m lion

.il

%


Page 88

A is incorrect because it neglects the incentive fee


Fund value after fees: $112 million − $1.12 million = $110.88 million

Investor return: 1108810

1 10880

$ . million$ mi ion

.ll

%


Page 89


QUESTIONS 41

A hedge fund with an initial value of $100 million has a management fee of 2% and anincentive fee of 20%. Management and incentive fees are calculated independently using end-of-period valuation. The value must reach the previous high-water mark before incentive feesare paid. The table below provides end-of-period fund values over the next three years.

Fund Value ($ millions)

Year Before Fees After Fees

1 120 113.6

2 110 107.8

3 125 ?


Page 90

The total amount of fees earned by the hedge fund in Year 3 is closest to:

A. $4.8 million.B. $5.5 million.C. $5.9 million.


Page 91

Solution

A is correct.

The incentive fee is based on the performance relative to the previous high-water mark afterfees.


Incentive fee: 20% of ($125 million − $113.6 million) = $2.28 million

In total: $2.5 million + $2.28 million = $4.78 million

B is incorrect because the incentive fee is incorrectly based on the fund value before fees in thesecond year.


Incentive fee: 20% of ($125 million − $110 million) = $3 million

In total: $2.5 million + $3 million = $5.5 million

C is incorrect because the incentive fee is incorrectly based on the fund value after fees in thesecond year.


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Incentive fee: 20% of ($125 million − $107.8 million) = $3.44 million

In total: $2.5 million + $3.44 million = $5.94 million


Page 93


QUESTIONS 42

In commodity futures market pricing, when the convenience yield is higher than the cost ofcarry, the roll yield is positive for:

A. long futures.B. short futures.C. both long and short futures.


Page 94

Solution

A is correct.

The futures market is in backwardation when the convenience yield is higher than the cost ofcarry. The futures price then generally rolls up (moves up along the forward curve) to the spotprice curve as the expiry date of the futures contract approaches, which results in a positiveroll yield for the long positions. B and C are incorrect because when the futures market is inbackwardation, the roll yield for the short futures is negative, not positive.


Page 95


QUESTIONS 43

A hedge fund begins the year with $120 million and earns a 25% return for the year. The fundcharges a 1.5% management fee on end-of-year fund value and a 15% incentive fee on thereturn, net of the management fees, that is in excess of a 6% fixed hurdle rate. The fund’sinvestors’ return for the year, net of fees, is closest to:

A. 20.56%.B. 21.25%.C. 19.66%.


Page 96

Solution

A is correct.The $120 million grows by 25% to $150 million [= $120 million × (1 + 0.25)]. The managementfee is $2.25 million (= $150 million × 0.015), leaving $147.75 million, net of the managementfee, or an increase of $27.75 million over the beginning value of $120 million. The 6% hurdlerate requires an increase of $7.2 million (= $120 million × 0.06), so the fund has earned $20.55million (= $27.75 million − $7.2 million) over the hurdle rate, net of the management fee.

The incentive fee is 15% of this, or $3.0825 million (= $20.55 million × 0.015), leaving anincrease in fund assets, net of management and incentive fees, of $24.6675 million (= $27.75

million − $3.0825 million). The investors’ return, net of fees, is 24 6675 20 56120

$ . . %

$ millionB is incorrect because it ignores that management fee. The fund grows to $150 million.Incentive fee is ($150 million − $120 million) × 0.15 = $4.5 million$150 million − $120 million − $4.5 million = $25.5 million25 5 0 2125120

$ . million .$ million


Page 97

C is incorrect because it fails to adjust for the hurdle rate when calculating the incentive fee or0.15 × $27.75 million =$4.1625 million and $27.75 million − $4.1625 million = $23.5875 million.23 5875 19 66120

$ . million . %

$ million


Page 98


QUESTIONS 44

High-water marks are typically used when calculating the incentive fee on hedge funds. Theyare most likely used by clients to:

A. avoid prime brokerage fees.B. avoid paying twice for the same performance.C. claw back the management fees.


Page 99

Solution

B is correct.

High-water marks help clients avoid paying twice for the same performance. When a hedgefund’s value drops, the manager will not receive an incentive fee until the value of the fundreturns to its previous level.

A is incorrect because high-water marks are not linked to prime brokerage fees.

C is incorrect because management fees are paid irrespective of returns.


Page 100

G. Describe risk management of alternative investments

QUESTIONS 45

An investor who has positions in multiple long–short equity hedge funds and is concernedabout whether these positions are sufficiently diversified will mostly likely be concerned aboutthe lack of:

A. transparency in reported positions.B. frequent independent valuations.C. liquidity in the underlying assets.


Page 101

Solution

A is correct.

Long–short hedge funds invest in liquid, publicly traded equity (taking long and shortpositions); therefore, the underlying positions can be reversed easily and there is no need forindependent valuations because current market prices are available. The investor will havedifficulty in determining if the different funds are holding diverse or concentrated positions(both within each fund and between funds) because hedge funds generally do not reveal theirholdings.

B is incorrect because these funds hold publicly traded securities with fresh market prices.

C is incorrect because these funds hold publicly traded securities that trade in liquid markets.


Page 102


QUESTIONS 46

The value at risk of an alternative investment is best described as the:

A. probability of losing a fixed amount of money over a given time period.B. minimum amount of loss expected over a given time period at a given probability level.C. time period during which a fixed amount is lost at a given probability level.


Page 103

Solution

B is correct.

Value at risk is defined as the minimum amount of loss expected over a given time period at agiven probability level.

A is incorrect because value at risk is defined as the minimum amount of loss expected over agiven time period at a given probability level.

C is incorrect because value at risk is defined as the minimum amount of loss expected over agiven time period at a given probability level.


Page 104


QUESTIONS 47

Investors will most likely have difficulty managing diversification across hedge funds if thefunds:

A. make decisions via investment committees.B. fail to appoint chief risk officers.C. seek to keep their strategies private.


Page 105

Solution

C is correct.

The lack of transparency in positions and strategies makes it difficult for investors to effectivelymanage diversification across funds.

A is incorrect because decision making by an investment committee does not limit theinformation needed for an investor when considering diversification benefits.

B is incorrect because failure to appoint a chief risk officer does not limit the informationneeded for an investor when considering diversification benefits.


Page 106


QUESTIONS 48

Alternative investments that rely on estimates rather than observable market prices forvaluation purposes are most likely to report:

A. returns that are understated.B. volatility of returns that is understated.C. correlations of returns with the returns of traditional assets that are overstated.


Page 107

Solution

B is correct.

The use of estimates tends to smooth the return series. As a consequence, the volatility ofreturns will be understated.

A is incorrect because there is a tendency for returns to be overestimated or at leastsmoothed.

C is incorrect because correlations of returns with the returns of traditional assets tend to beunderstated as a consequence of smoothing the return series.

cfa level - 1...2018/09/28 · cfa level - 1 alternative investment page 8 solution b is correct....

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