01 alternative investments for portfolio management

Alternative Investments for Portfolio Management

Test ID: 7428164

Question #1 of 101

Question ID: 466289

With respect to adding managed futures investing to a stock and bond portfolio:
ᅞ A) a trend-following strategy will offer more diversification than a contrarian
strategy.
ᅞ B) a trend-following strategy will offer diversification equal to that of a contrarian strategy.
ᅚ C) a trend-following strategy will offer lower diversification than a contrarian strategy.
Explanation
For managed futures funds, a trend-following strategy will offer lower diversification 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 diversification. The
market for the underlying securities will also play a role.

Question #2 of 101

Question ID: 466327

With respect to venture capital (VC) funds and buyout funds, measuring returns accurately is:
ᅚ A) more difficult with VC funds than with buyout funds.
ᅞ B) less difficult with VC funds than with buyout funds.
ᅞ C) equally difficult with VC funds as it is with buyout funds.
Explanation
The difference is a natural consequence of the buyout funds purchasing entities in later stages of development.

Question #3 of 101

Question ID: 466294

With respect to managed futures and real estate, legal issues and valuation methods are special due diligence issues
associated with:
ᅚ A) real estate only.
ᅞ B) managed futures only.
ᅞ 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.


Question #4 of 101

Question ID: 466309

When added to a portfolio of stocks and bonds, based upon historical performance, we can expect distressed securities to
contribute:
ᅞ A) enhanced return but not diversification.
ᅞ B) diversification but not enhanced return.
ᅚ C) both enhanced return and diversification.
Explanation
They can provide high returns because many investors cannot hold distressed debt securities, and few analysts cover the
market. Based on comparisons of the average and Sharpe ratio, the HFR Distressed Securities Index outperformed both
stocks and bonds both absolutely and on a risk-adjusted basis. The returns are often event-driven so the return is
uncorrelated to the overall stock market and can provide diversification.

Question #5 of 101

Question ID: 466287

In the special issues that alternative investments raise for investment advisors of private wealth clients, with respect to tax
issues and suitability:
ᅚ A) both are explicitly special issues to consider.
ᅞ B) suitability is a special issue to consider but tax issues are not.
ᅞ 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.

Question #6 of 101

Question ID: 466340

In making investments in private equity, diversification is:
ᅞ A) not possible to any investor.
ᅚ B) possible by holding a number of positions, but usually only for investors with portfolios
over $100 million.
ᅞ C) possible by holding a number of positions, and the size of the portfolio is not an issue.
Explanation
Diversification 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 diversification.

Question #7 of 101

Question ID: 466331


Compared to common stockholders, investors who use convertible preferred stock to make venture capital investments will
receive the promised dividend:

ᅞ A) only if common stockholders receive a dividend or a disbursement through
liquidation.
ᅞ B) before common stockholders receive a dividend but not if there is a liquidation.
ᅚ C) before common stockholders receive a dividend or a disbursement through
liquidation.
Explanation
Preferred stockholders must be paid a specified amount, say twice the initial investment, before common stockholders can
receive cash in the form of dividends or distributions through liquidation.

Question #8 of 101

Question ID: 466338

For hedge funds, the basic incentive fee for managers may not be adequate because:
ᅞ A) they are usually too low, e.g., 2% or less.
ᅞ B) a manager usually earns a minimum incentive fee regardless of the performance of
the fund.
ᅚ C) a hedge fund manager may have several goals other than earning a high return, e.g.,
lowering downside risk.
Explanation
The rationale for incentive fees is obvious: encourage the manager to earn higher profits. 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 diversification. The basic incentive fee does not reward this
service.

Question #9 of 101

Question ID: 466337

Hedge fund managers with good track records:

ᅚ A) often demand higher incentive fees.
ᅞ B) usually lower their fees to increase the assets under management.
ᅞ C) generally continue to have good track records.
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.

Question #10 of 101

Question ID: 466367


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

Question #11 of 101

Question ID: 466281

Which of the following is least likely to be a due diligence checkpoint in the selection process of active managers of alternative
investments?
ᅞ A) Market opportunity the manager seeks to exploit.

ᅞ B) The service providers like lawyers and ancillary staff working for the manager's firm.
ᅚ C) The geographic location of the office with respect to the geographic locations in which
the manager invests.
Explanation
The due diligence checkpoint list does not mention the geographic location of the offices.

Question #12 of 101

Question ID: 466326

Which stage of financing generally supports further expansion of production and sales?
ᅚ A) The second stage.
ᅞ B) The third stage.
ᅞ C) The first stage.
Explanation
The second stage of financing supports further expansion of production and sales. The third stage of financing typically can
support additional major expansion. First stage funding is used to begin manufacturing and sales.

Question #13 of 101
With respect to commodities and managed futures, which have investable indices?
ᅚ A) Both commodities and managed futures.

Question ID: 466303


ᅞ B) Commodities but not managed futures.
ᅞ C) Neither commodities nor managed futures.
Explanation
Indices for both asset classes use trading rules and assets to which investors have access.

Question #14 of 101

Question ID: 466344

Direct investment in commodities has become easier for all investors because of the:
ᅚ A) the increase in the number of commodity indices.
ᅞ B) increased number of hedge funds in these markets.
ᅞ C) increase in hedging activities of managers in firms that produce and/or deal in
commodities.
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.

Question #15 of 101

Question ID: 466345

Compared to indirect investments in commodities, direct investments offer:
ᅚ A) more exposure to commodity returns but higher carrying costs.
ᅞ B) less exposure to commodity returns and higher carrying costs.
ᅞ C) less exposure to commodity returns but lower 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.

Question #16 of 101

Question ID: 466365

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:
ᅞ A) would be more liquid.
ᅚ B) would have a lower correlation with equity markets.
ᅞ 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.

Question #17 of 101

Question ID: 466379

In distressed securities investing, the type of risk that is from the human element associated with decisions determined in a
court of law is called:
ᅚ A) J-factor risk.
ᅞ B) event risk.
ᅞ C) decision risk.
Explanation
In J-factor risk, the "J factor" refers to the role that courts and judges can play in the return, and this involves an unpredictable
human element.

Question #18 of 101

Question ID: 466334

Which of the following most likely represents the compensation to a sponsor of a private equity fund?
ᅞ A) A management fee of 10% and an incentive fee of 10%.
ᅚ B) A management fee of 2% and an incentive fee of 20%.
ᅞ C) A management fee of 2% and an incentive fee of 2%.
Explanation
As a manager, the sponsor gets a management fee and incentive fee. The management fee is usually around 1.5%-2.5%, and
is based upon the committed cash and not just the cash already invested. The percent may decline over time based upon the
assumption that the sponsor's work declines over time. The incentive fee is the share of the profits, usually around 20%, that is
paid to the manager after the fund has returned the outside investors' capital.

Question #19 of 101

Question ID: 466374

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:
ᅞ A) an orphan equity fund.
ᅚ B) a vulture fund.
ᅞ C) a high yield 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 influence 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.

Question #20 of 101

Question ID: 466308

For use in evaluating hedge funds, which of the following is NOT a shortcoming of the Sharpe ratio?
ᅞ A) It has had little success in predicting winners.
ᅚ B) It uses an arbitrary reference return.
ᅞ C) It is a stand-alone measure that ignores the diversification contributions of a hedge
fund to an overall portfolio.
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.

Question #21 of 101

Question ID: 466366

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:
ᅞ A) both survivorship bias and style drift.
ᅚ B) survivorship bias only.
ᅞ 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.

Question #22 of 101

Question ID: 466322

With respect to buyers of venture capital, which group represents the first group to invest in the company after the initial
entrepreneurs and their friends and family?
ᅚ A) Angel investors.
ᅞ B) Strategic partners.
ᅞ C) Venture capitalists.


Explanation
Buyers of venture capital include angel investors who are usually accredited investors and the first outside investors after the
family and friends of the company founders. Venture capitalists come in later after identifying companies with potential but
need financial and strategic support. Further, large companies are usually in the same industry as the issuer and are also
called strategic partners.

Question #23 of 101

Question ID: 466290

Which of the following is least likely to be included in private equity subgroups?
ᅚ A) Futures funds.
ᅞ B) Private investment in public entities.
ᅞ C) Start-up companies.
Explanation
Private equity subgroups are start-up companies, middle-market private companies, and private investment in public entities.
The distinguishing feature for the subgroups is the stage of development of the company to which the invested dollars flow.

Question #24 of 101

Question ID: 466377

In distressed securities investing, event risk is:
ᅚ A) a source of both return and diversification.
ᅞ B) a source of diversification only.
ᅞ C) a source of return only.
Explanation
Event risk refers to the fact that the return on a particular investment within this class typically depends on a particular event
for a company, and that can provide good diversification.

Question #25 of 101

Question ID: 466323

With respect to the terms "formative-stage companies" and "expansion-stage companies", which are considered issuers of
venture capital?
ᅞ A) Formative-stage companies only.
ᅞ B) Neither formative-stage companies nor expansion-stage companies.
ᅚ C) Both formative-stage companies and 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 IPO.


Question #26 of 101

Question ID: 466336

If a hedge fund goal is the elimination of systematic risk, a problem for the fund in motivating the manager is that:
ᅚ A) the standard incentive fee only applies to raw earnings and would not reward
the elimination of systematic risk.

ᅞ B) the standard incentive fee only applies to assets under management and would not
reward the elimination of systematic risk.
ᅞ C) it is impossible to gauge the degree to which systematic risk has been eliminated.
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 diversification. The basic incentive
fee does not reward this service.

Question #27 of 101

Question ID: 466286

In the special issues that alternative investments raise for investment advisors of private wealth clients, "decision risk" is
associated with:
ᅞ A) making hiring and firing decisions and general employee turnover of the
investment firm.
ᅚ B) changing a strategy at the time the portfolio has incurred a large loss.
ᅞ C) assessing the investment opportunity.
Explanation
Decision risk is the risk of irrationally changing a strategy.

Question #28 of 101

Question ID: 466358

Commodities can be categorized into storable and nonstorable. Which category, if any, should an analyst recommend as a
hedge against inflation?
ᅞ A) Nonstorable commodities.
ᅚ B) Storable commodities.
ᅞ C) Both storable and nonstorable 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.


Question #29 of 101

Question ID: 466311

When compared to a portfolio of publicly traded stocks, private equity is:
ᅚ A) correlated with stocks but adds moderate diversification because of its
idiosyncratic risk component.
ᅞ B) correlated with stocks and has a low idiosyncratic risk component so it adds virtually
no diversification.
ᅞ C) uncorrelated with stocks and adds a high degree of diversification.
Explanation
Private equity returns typically move with stock market returns. Computed correlations are often positive and low, but some
attribute the low correlation to the infrequently-updated or "stale" prices of the private equity returns. Each investment has a
large idiosyncratic risk component, however, which can provide moderate diversification.

Question #30 of 101

Question ID: 466335

In the life of a private equity fund, capital calls represent the:
ᅞ A) request for more capital by the fund sponsor from the investors after the
commitment period.
ᅚ B) request for more capital by the fund sponsor from the investors during the
commitment period.
ᅞ 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 first five years (typically) called the commitment period to bring in the promised cash.

Question #31 of 101

Question ID: 466321

Direct equity real estate investing has all of the following advantages over indirect real estate investing EXCEPT:
ᅚ A) lower information costs.
ᅞ B) tax deductible expenses.
ᅞ C) the ability to manage geographic diversification.
Explanation
Direct equity real estate investing has the following advantages: many expenses are tax deductible, the ability to use more
leverage than other investments, having more control, and the ability to diversify geographically. Higher information costs are
a disadvantage to direct real estate investing.


Question #32 of 101

Question ID: 466361

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:
ᅞ A) the Hera Fund only.
ᅞ B) either fund.
ᅚ 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.

Question #33 of 101

Question ID: 466325

Which of the following is an example of an issuer of venture capital?
ᅞ A) Venture capitalists.
ᅞ B) Large, successful corporations.
ᅚ C) Formative-stage companies.
Explanation
Formative-stage companies are young companies seeking capital, so therefore they are an example of an issuer of venture
capital. Venture capitalists are specialists who identify pools of capital available for investing in and find the promising private
companies to invest in. Thus, venture capitalists are suppliers of venture capital. Large companies that invest, or supply,
venture capital opportunities in their own area of business expertise is referred to as corporate venturing.

Question #34 of 101

Question ID: 466277

Special due diligence issues such as valuation, credit analysis, and financial structure are most likely associated with
investments:
ᅞ A) in managed futures.
ᅚ B) in distressed securities.
ᅞ 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.


Question #35 of 101

Question ID: 466291

Within the alternative asset class of real estate, analysts can classify investments as:
ᅞ A) either direct or indirect and as either start-up or middle market.
ᅞ B) either start-up or middle market but not as direct or indirect.
ᅚ C) either direct or indirect but not as either start-up or middle market.
Explanation
Real estate investments are generally categorized as direct (i.e., the purchase of land and buildings) or indirect that includes
REITs and CREFs. The sub-categories of start-up and middle market apply to private equity and not real estate.

Question #36 of 101

Question ID: 466305

With respect to hedge fund indices, back-fill bias refers to:
ᅚ A) a hedge fund manager filling in historical values of his/her hedge fund's
performance when the fund has been selected to be included in an index.
ᅞ B) the increased inflow of investments to a given fund in an index right after the style of
the index has performed well.
ᅞ C) modifying the historical series of the index by replacing the historical returns of
recently dropped funds with the historical returns of new funds added to the index.
Explanation
Biases often exist in hedge fund indices because of the self-reporting of fund returns. This can apply to returns as they are
earned or when filling in gaps in the historical data. The inclination is to over report. Backfill or inclusion bias is the name of the

potential bias when a hedge fund joins an index and the manager adds historical data to complete the series.

Question #37 of 101

Question ID: 466371

A commodity pool operator (CPO) is deciding whether or not to hire a particular commodity trading advisor (CTA). The CTA
has a good track record of performance and often exhibits negative correlation with equities thus enhancing overall
performance in down markets. Which of the following statements regarding whether or not the CPO should hire the CTA is
most accurate? The CPO should:
ᅚ A) hire the CTA only if its beta and correlation have been considered in
determining its risk relative to the pool of operators.
ᅞ B) not hire the CTA if their beta relative to other CTAs managing the pool of futures
contracts is too low, as this indicates that the CTA's past returns are low relative to the
pool of operators.
ᅞ C) not hire the CTA if their past performance is highly correlated with the pool of
operators, as this indicates their volatility relative to the pool is high.
Explanation


In selecting a CTA to include in the portfolio, the manager should consider risk. For example, even though CTAs often exhibit
negative correlations with equities, correlations among CTAs themselves can range anywhere from significantly positive (i.e.,
close to 1.0) to only modestly positive. In addition, the beta that relates the performance of an individual CTA to a fund of
CTAs can be a good indicator of future risk-adjusted performance. Just as equity beta relates the volatility (risk) of an
individual equity security or portfolio to the overall equity market, the CTA beta measures the risk of the individual CTA relative
to a fund of CTAs.

Question #38 of 101

Question ID: 466342

Diversification is one of the major issues that must be addressed when formulating a private equity investment strategy. To be
considered diversified, investors must be able to invest in 5 to 10 different investments. In order to do this investors must
typically have portfolios of at least:
ᅞ A) $500 million.
ᅚ B) $100 million.
ᅞ C) $250 million.
Explanation
Investors typically need to have portfolios of at least $100 million in order to be able to invest in 5 to 10 different investments
and be considered diversified through a number of positions.

Question #39 of 101

Question ID: 466328

In contrast to venture capital funds, buyout funds usually have:
ᅞ A) less frequent losses and more upside potential.
ᅚ B) less frequent losses and less upside potential.
ᅞ C) more frequent losses and more upside potential.
Explanation
These differences are the natural consequence of the buyout funds purchasing entities in later stages of development or even
established companies where the risks are lower.

Question #40 of 101

Question ID: 466332

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:

ᅞ A) ranks ahead of debt investors.
ᅞ B) has dividends that can increase.
ᅚ C) benefits in the event of a company buyout.


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 fixed.

Question #41 of 101

Question ID: 466360

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

Question #42 of 101

Question ID: 466370

Which of the following statements regarding what a managed futures trading strategy is called and how it is described is least
accurate?
ᅚ A) Unsystematic – the commodity trading advisor tracks specific commodity
futures contracts and uses trading rules to signal when to buy and sell the

contract.
ᅞ B) Discretionary – the commodity trading advisor uses their own discretion to buy futures
contracts they feel are over or undervalued.
ᅞ C) Systematic – the commodity trading advisor trades according to market trends and
may even use a contrarian strategy which trades against the market trend.
Explanation
Commodity trading advisor (CTA) strategies can be described as systematic or discretionary (not unsystematic). CTAs that
specialize in systematic trading strategies typically apply sets of rules to trade according to short, intermediate, and/or longterm trends. They may also trade counter to trends in a contrarian (against the trend) strategy.
A discretionary trading strategy is based on the discretion of the CTA, in the same way that any active manager seeks
value.
Managed futures can also be classified according to the markets in which they trade. They apply systematic or discretionary
trading strategies in financial markets, currency markets, or diversified markets. In financial markets, they trade in financial
(i.e., interest rate) and currency futures, options, and forward contracts. Those that specialize in currency markets trade
exclusively in currency derivatives. A fund that trades in diversified markets trades in all the financial derivatives markets
described as well as commodity derivatives.


Question #43 of 101

Question ID: 466302

With respect to weighting schemes for hedge fund indices, the weighting schemes:
ᅚ A) can be either equally weighted or based upon assets under management.
ᅞ B) are always based upon assets under management.
ᅞ C) are always equally weighted.
Explanation
Weighting schemes are usually either equally weighted or based upon assets under management.

Question #44 of 101

Question ID: 466276

With respect to the role of alternative assets in a portfolio, it can be best described as exposure to:
ᅞ A) unique asset classes only.
ᅚ B) unique asset classes and/or special investment strategies.
ᅞ C) special investment strategies.
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 that invest in private equity and
distressed securities).

Question #45 of 101

Question ID: 466320

Direct equity real estate investing has the following disadvantages over indirect real estate investing EXCEPT:
ᅚ A) less control over the investment's performance.
ᅞ B) high commissions.
ᅞ C) political risk.
Explanation
Direct equity real estate investing has the following disadvantages: lack of divisibility means a single investment may be a large
part of the investor's portfolio. There are high information cost, high commissions, high operating and maintenance costs, and
hands-on management requirements. There are special geographical risks like neighborhood deterioration and the political
risk of changing tax codes.

Question #46 of 101
An investor in private equity needs to prepare for capital calls, which:

Question ID: 466339


ᅚ A) equal the funds promised at the initiation of the fund and usually occur during
the first five years of the fund.
ᅞ B) is additional money requested by the sponsor as mezzanine financing after the
commitment period.
ᅞ C) occurs at the beginning of the life of the fund before the commitment period.
Explanation
This is the definition of capital calls. The investors in private equity usually make commitments at the initiation of the fund.
During the first five years, or so, the sponsor gives the capital calls to the investors to get the promised funds.

Question #47 of 101

Question ID: 466285

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:
ᅚ A) not include measuring the ownership in the client's corporate bond portfolio
but would include measuring the client's ownership in closely held companies.
ᅞ B) include measuring the ownership in the client's corporate bond portfolio and the
client's ownership in closely held companies.
ᅞ C) not include measuring the ownership in the client's corporate bond portfolio and not
include measuring 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."

Question #48 of 101

Question ID: 466368

When evaluating hedge funds, special issues that complicate the process would include the fact(s) that:
ᅞ A) benchmarks are absolute return in nature and do not address other goals such
as the elimination of systematic risk.
ᅚ B) many hedge funds are absolute return vehicles for which no benchmark exists, and
they can use long/short strategies while most benchmarks are long only in nature.
ᅞ C) benchmarks are designed to be both long and short in nature, but most hedge funds
are long only.
Explanation
These are two problems in defining and creating benchmarks. One method for addressing problems in defining and creating
benchmarks is the use of single and multi-factor models. Thus, factor models do not pose a complication but offer a solution.


Question #49 of 101

Question ID: 466288

Ben Leesom, CFA, thinks distressed securities are appropriate for one of his clients and would like to include them in his
client's portfolio. If liquidity is a concern for the client, which alternative investment, either private equity or a hedge fund, would
be more appropriate?
ᅞ A) Either one since both have approximately the same liquidity.
ᅚ B) An investment with a hedge fund structure over a private equity structure.
ᅞ C) An investment with a private equity structure over a hedge fund structure.
Explanation
Distressed securities can be divided by the two indicated structures. Hedge fund structured investments are usually more
liquid than investments in distressed equity using the private equity structure.

Question #50 of 101

Question ID: 466373

Which of the following statements regarding the performance of managed futures is most accurate?
ᅞ A) Privately managed futures have not performed as well as publicly traded funds.
ᅞ B) Publicly traded managed futures have performed well on both a stand-alone and
portfolio basis.
ᅚ C) Managed futures have exhibited a positive correlation to equities and bonds during up
markets and a negative correlation during falling markets.
Explanation
The primary benefit to managed futures is the significant diversification potential (i.e., improved Sharpe ratios). For example,
some research has even shown that managed futures have exhibited positive correlation to equities and bonds during up
markets and negative correlations during falling markets, although the performance seems to be related to specific strategies
and time periods. In particular, private funds seem to add value whereas publicly traded funds have performed poorly both
stand-alone and in portfolios.

Question #51 of 101

Question ID: 466333

Which of the following most likely represents the timeline of a private equity fund?
ᅞ A) 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.
ᅞ B) The commitment period of 2 years, the life of the fund reaching 5 years, an option to
extend the fund 3 more years.
ᅚ 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 first five 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.

Question #52 of 101

Question ID: 466359

A hedge fund that focuses on earning returns from mergers, spin-offs, and takeovers would be most accurately placed in
which style category?
ᅚ A) Merger arbitrage.
ᅞ B) Hedged equity.
ᅞ C) Equity market neutral.
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.

Question #53 of 101

Question ID: 466343

Compared to direct investing in commodities, indirect investing is usually considered to be:
ᅞ A) just as convenient, which is very convenient.
ᅞ B) less convenient.
ᅚ C) more convenient.
Explanation
This is generally true, but indirect investment via companies that deal in the commodity may provide limited exposure to the
performance of the commodity.

Question #54 of 101

Question ID: 466363

With respect to the operations of a hedge fund, a high water mark is designed to:
ᅞ 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.
ᅚ B) prevent a manager from being paid twice for the same gains of the fund.
ᅞ 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."

Question #55 of 101
In contrast to venture capital funds, buyout funds usually have a:

Question ID: 466329


ᅞ A) lower level of leverage and earlier and steadier cash flows.
ᅞ B) higher level of leverage and later and more erratic cash flows.
ᅚ C) higher level of leverage and earlier and steadier cash flows.
Explanation
Buyout funds are usually investing in later-stage companies where the risks are lower. The cash flows are steadier and the
investors can use more leverage.

Question #56 of 101

Question ID: 466330

The convertibilty feature in convertible preferred stock is important because it means that preferred stockholders:
ᅚ A) can benefit from a buyout favorable to common stockholders.

ᅞ B) can convert their claims to equal those of later investors in the company.
ᅞ C) can block a possible buyout.
Explanation
Any buyout of the company that is favorable to shareholders will lead to the conversion of the preferred stock.

Question #57 of 101

Question ID: 466307

One problem in creating a private equity index is the:
ᅚ A) infrequent repricing of the components.
ᅞ B) issue of leverage and how to deal with it.
ᅞ C) problems with defining what constitutes a private equity investment.
Explanation
The value of a private equity index depends upon price-revealing events like IPOs, mergers, the raising of new financing, etc...
Thus, the re-pricing of the index occurs infrequently.

Question #58 of 101

Question ID: 466348

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?
ᅚ A) $3.00.
ᅞ B) $31.00.
ᅞ C) $6.89.
Explanation
Total return = spot return + collateral return + roll return.

Collateral return = total return − spot return − roll return.

$3 = $17 − $9 − $5

Question #59 of 101

Question ID: 466369

When evaluating the performance of a hedge fund that uses leverage, the convention is to:
ᅞ A) not attempt to evaluate the fund because the existence of leverage makes such
an assessment impossible.
ᅚ B) treat an asset as if it were fully paid to effectively "look through" the leverage.
ᅞ 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 effectively "look through" the leverage.
When derivatives are included, the same principle of deleveraging is applied.

Questions #60-65 of 101
Suzanne Harlan has a large, well-diversified stock and bond portfolio. She wants to try some alternative investments, and has
contracted with Laurence Philips, principal of Philips Finance, to help assemble a new portfolio.
Before agreeing to make recommendations for Harlan, Philips wants to determine whether she is a good candidate for
alternative investments. He gives her a standard questionnaire that asks open-ended questions of all potential clients. Here
are some of Harlan's comments:
"I'm interested in high returns. I'm not afraid of risk, and I'm investing this money for the benefit of my eventual heirs."
"I pay several million dollars in taxes every year, and I want any additional investments to be tax-friendly."
"While I expect risk on an individual-investment basis, I'd like to further diversify my portfolio and reduce overall risk."
"I pay a lot of attention to expense and return data from my investments and track their performance closely."
"I'm 65 years old and in excellent health."
After reading Harlan's responses and learning that she is a fairly sophisticated investor, Philips agrees to take her on as a
client. Harlan has a lot of experience with investments and has some ideas what she'd like to do. She brings Philips the

following ideas:
"I have a colleague in the lumber business who says the furniture market is booming, and demand should increase in the
year ahead. I'd like to purchase some lumber futures in the hopes that the price will rise."
"Hedge funds are earning excellent returns, and I expect them to continue doing so. However, other investors have told
me that the difficulty lies in assessing the quality of the funds, because they are not well regulated. So I'm interested in
purchasing a fund of funds, so I can diversify my risk while potentially sharing in some outsized returns."
"I already own a couple of REITs, but they represent a very small portion of my assets, and I'd like to increase my
exposure to real estate. I've heard about pooled real estate funds, and I'm interested in one of those funds."
"My neighbors founded Kelly Tool and Die, a machine-tool business, 20 years ago and have not managed the company
well. They have told me they are considering filing for bankruptcy. I have contacts in the manufacturing business overseas
who would be interested in acquiring Kelly's assets. My Asian colleagues are willing to pay about 60% of book value for the
assets, and my neighbors are willing to sell me the company for about 50% of the book value of its assets."


Harlan then tells Philips that it is imperative that the returns of any investments he recommends must be in some way
comparable to a benchmark.
Philips is not excited about the commodity idea and does not like funds of funds. However, he does know of several managers
of individual hedge funds that might interest Harlan. He talks her out of the fund of funds idea and suggests she put her money
in the Stillman Fund, which is run by one of his college friends. Fund manager Mark Stillman concentrates on spin-offs,
generally buying the spun-off company and shorting the parent company.

Question #60 of 101

Question ID: 466313

Harlan seeks alternative investments that will both boost returns and diversify her portfolio. Which pair of her proposed
investments represents the worst choices for each goal?
Net returns

Diversification

ᅞ A) Real estate funds Hedge funds
ᅚ B)

Lumber

ᅞ C) Lumber

Kelly Tool and
Die
Hedge funds

Explanation
Commodity investments are primarily diversification tools, having little correlation with traditional stocks and bonds. The Kelly
Tool and Die investment is private equity, which is more of a return enhancer than a diversifier. Real estate funds can boost
both diversification and returns, while hedge funds can boost returns, diversify, or both, depending on the nature of the fund.
(Study Session 13, LOS 26.f)

Question #61 of 101

Question ID: 466314

Based on her investment suggestions and survey answers, Harlan is least concerned with:
ᅚ A) liquidity.
ᅞ B) volatility.
ᅞ C) inflation.
Explanation
While Harlan's comment about being willing to accept risk may suggest she is not concerned about volatility, she is most
definitely concerned on a portfolio level, as evidenced by her desire to use alternative assets for diversification purposes.
Nothing in the information presented above offers any hint about Harlan's concerns about inflation. However, Harlan's stated

desire to build wealth for her heirs suggests liquidity is not a concern. (Study Session 13, LOS 26.f)

Question #62 of 101

Question ID: 466315

In his attempt to talk Harlan out of investing in a fund of funds, Philips addressed the advantages of investing in individual
funds. Which of the following is his most compelling argument?
ᅞ A) The likelihood of style drift in a fund of funds.
ᅚ B) The lower expenses of individual funds.


ᅞ C) The lack of benchmarks for a fund of funds.
Explanation
The biggest disadvantage of the fund of funds is the extra layer of fees. Style drift could be an issue for both an individual
hedge fund and a fund of funds, much as it is with traditional mutual funds. The issue with benchmarks is probably more
troubling for individual funds than for funds of funds. (Study Session 13, LOS 26.r)

Question #63 of 101

Question ID: 466316

The Stillman fund uses which strategy?
ᅞ A) Relative value.
ᅞ B) Hedged equity.
ᅚ C) Merger arbitrage.
Explanation
Merger arbitrage funds usually focus on mergers, spin-offs, or takeovers, buying one company in the transaction and shorting
the other. (Study Session 13, LOS 26.p)

Question #64 of 101

Question ID: 466317

Which of Harlan's responses is most likely to make Philips consider her a bad candidate for alternative investments?
ᅞ A) "I pay several million dollars in taxes every year, and I want any additional
investments to be tax-friendly."
ᅚ B) "I pay a lot of attention to expense and return data from my investments and track
their performance closely."
ᅞ C) "I'm interested in high returns. I'm not afraid of risk, and I'm investing this money for
the benefit of my eventual heirs."
Explanation
Many alternative assets provide high returns, and a high risk tolerance and low need for liquidity are positives for investors in
alternative asset classes. And while many alternative assets are risky, they can provide a substantial diversification benefit
when combined with mainstream investments. Many alternative investments are tax-friendly. However, most of the
investments considered for this exam are not easy to value, and difficult to track closely over short periods of time. (Study
Session 13, LOS 26.a)

Question #65 of 101

Question ID: 466318

If Harlan is truly concerned about benchmarks, she should avoid which of her suggested investments?
ᅞ A) Hedge funds.
ᅞ B) Kelly Tool and Die.
ᅚ C) None of them, benchmarks are available for all asset classes.
Explanation
Benchmarks are available for commodities, real estate, private equity, and hedge funds, though not all of them are easy to

interpret. (Study Session 13, LOS 26.e)

Questions #66-71 of 101
Hollis, Ignitowski, Jacobs, and Kelso are four analysts working in a windowless basement office at Madison Partners, a money
manager specializing in alternative investments. They have an ongoing debate over which alternative-investment vehicle is
best. As is often the case in long-running feuds, each frequently refers back to a favorite argument.
Hollis: "I like receiving convertible preferred stock for my venture-capital investments because my claim is usually senior to
those of investors who get in later."

Ignitowski: "Agricultural commodity investments are better, because they provide an inflation hedge and have traditionally
delivered better returns than bonds."

Jacobs: "Private-equity limited partnerships not only limit the potential losses of initial investors, but also avoid double
taxation."

Kelso: "A fund of funds has less survivorship bias than an index, and it rarely falls prey to style drift."
Opinions about investment classes aside, the four Madison analysts are tasked with performing due diligence on hedge funds.
Hedge funds are notoriously difficult to analyze, and the analysts divide up the task, with each focusing on a certain aspect of
the due diligence.
Hollis considers the hedge fund's strategy, looking at the investment style as well as the individual investments to assess
whether the fund is likely to outperform not only the market, but other hedge funds. In this analysis, he also considers the
fund's financial policies and market risk profile, using downside deviation rather than standard deviation. Hollis also considers
the age of the fund. He prefers funds that have been around for awhile because experienced management gives the funds an
edge. Lastly, Hollis' duties also include reviewing the funds' structure, examining who manages, audits, or regulates the fund.
Ignitowski focuses on performance data. Because hedge funds are not well regulated, they have a lot of freedom regarding
how they present performance data. Ignitowski drills down into the performance of individual holdings to assess whether the
stated returns are accurate. He then recalculates cumulative performance data using weekly returns, adjusting when possible
for inflows and outflows. Ignitowski prefers larger funds since they have historically outperformed smaller funds.
Jacobs tackles the administrative details, starting with an analysis of the fund's fee structure. He researches legal issues,
including pending lawsuits, regulatory actions, and lock-up provisions. Jacobs' review also addresses personnel issues,

including the amount of staff, turnover rates, and, when possible, rates of compensation.
Kelso calls investors in the hedge fund for references. He asks about investors' knowledge of the managers' investment styles
and whether they deviate from the stated style.
After the four analysts compile their analysis of hedge funds, their due diligence is forwarded upstairs to the investment
director, Francine Finster. She does not see the analysts' e-mail on this particular day because she is in conference with Dan
Braden, a dot-com millionaire who retired at 35 with just one goal: becoming a billionaire. Braden considers his portfolio of
traditional investments - 60 percent large-cap stocks, 20 percent small-cap stocks, and 20 percent bonds -- well-diversified for
his age and level of wealth, but his knowledge of alternative investments is not extensive, and he is consulting Madison
Partners for help with that portion of his portfolio.
Braden has high hopes for his portfolio. He wants Finster to find him an asset class that will provide better returns than stocks
and a higher Sharpe ratio than bonds, while at the same time bringing an additional diversification benefit to the portfolio.
Finster promises to look at some indexes and do some research into historical returns of various asset classes in an attempt


to find this investment, but doubts she can find anything that will meet Braden's criteria.
Finster convinces Braden to allow Madison to manage his alternative investments. She immediately purchases a security for
him, expecting it to lower his annual returns but increase his Sharpe ratio.
Looking ahead, Finster expects Braden to be a fairly difficult customer, demanding very high returns and creative strategies.
She decides that he might like the idea of a swap. Finster prefers interest-rate and commodity swaps but has not been
involved in either type of transaction for a number of months. To refresh her memory, she wrote down some bullet points
comparing the two types of swaps:
The value of an interest-rate swap will change over time if market rates change, but will not change over time if market
rates stay the same, even if prices change.
The value of a commodity swap will change over time regardless of whether market rates or prices change.
Both interest-rate and commodity swaps have a value of zero initially.
In the event of a change in market rates, the value of both an interest-rate swap and a commodity swap will change.

Question #66 of 101

Question ID: 466296

The alternative investment Finster added to the Braden portfolio is least likely to be:
ᅞ A) a direct real estate investment.
ᅚ B) a venture-capital fund.
ᅞ C) commodity futures.
Explanation
Venture capital funds generally behave like private equity, and are designed to boost returns, not diversify. Futures and real
estate are traditionally used as diversification tools and are likely to lower overall returns for a stock-heavy portfolio. As such,
venture-capital is the least likely to reduce returns while raising the Sharpe ratio. (Study session 13, LOS 26.d)

Question #67 of 101

Question ID: 466297

Which of the Madison analysts does NOT ignore hedge-fund conventions?
ᅞ A) Ignitowski, with his opinions about fund size.
ᅚ B) Hollis, with his measure of fund risk.
ᅞ C) Hollis, with his opinions about fund age.
Explanation
Common hedge-fund conventions include, "large funds underperform small funds," "young funds outperform old funds," and
the use of simple monthly returns compounded over 12 periods. The analysts do not follow these conventions. While standard
deviation is a common convention for calculating the risk of equity and debt investments, downside deviation is commonly
used for hedge funds. As such, Hollis' measure of fund risk is in keeping with hedge-fund convention. (Study session 13, LOS
26.s)

Question #68 of 101
Based on historical data, Finster can most likely meet Braden's lofty goals by investing in:
ᅞ A) venture capital.
ᅚ B) distressed securities.

Question ID: 466298


ᅞ C) nothing, because no asset class meets those requirements.
Explanation
The HFR Distressed Securities index outperforms both stocks and bonds absolutely, with higher Sharpe ratios than either. It is
also poorly correlated with the stock market, so it would diversify a stock portfolio. Private equity has historically delivered
better returns than stocks, but it is highly correlated with the stock market, and Sharpe ratios can be quite high. Direct
investments in real estate generally provide returns lower than those of stocks, though they do provide substantial
diversification benefits. (Study session 13, LOS 26.f)

Question #69 of 101

Question ID: 466299

Which of Finster's notes about swaps is least accurate?
ᅞ A) Both interest-rate and commodity swaps have a value of zero initially.
ᅚ B) The value of an interest-rate swap will change over time if market rates change, but
will not change over time if market rates stay the same, even if prices change.
ᅞ C) The value of a commodity swap will change over time regardless of whether market
rates or prices change.
Explanation
The values of both interest-rate swaps and commodity swaps will change over time regardless of movement (or lack thereof)
in market rates or prices. Both types of swaps do indeed have a value of zero at inception, and a change in market rates will
affect the value of both types of swaps.

Question #70 of 101

Question ID: 466300

The Madison due diligence for hedge funds is detailed, but not comprehensive. Which traditional aspect of due diligence is
neglected?
ᅚ A) Analysis of the fund's research expenditures.
ᅞ B) Consideration of the fund's use of leverage.
ᅞ C) Assessment of the fund's suitability for particular investors.
Explanation
A review of the fund's competitors is a good idea, but it is not part of due diligence. Neither is an assessment of the fund's
suitability for particular investors. Both of those reviews should be part of the investment decision, but due diligence normally
means an analysis of how the fund operates, rather than its investment merits relative to outside criteria. The fund's use of
leverage would fall under Hollis' expertise as he considers the investment style, financial policies, and risk profile. Madison
Partners appears to have this issue well in hand. However, the fund's research strategy and expenditures are key to
understanding how the fund operates, and none of Madison's analysts appears to address this topic. (Study session 13, LOS
26.b)

Question #71 of 101
Which of the Madison Partners made the most accurate statement about alternative investments?
ᅚ A) Jacobs.
ᅞ B) Ignitowski.

Question ID: 466301