READING 50: INTRODUCTION TO ALTERNATIVE INVESTMENTS
LOS 50.a: Compare alternative investments with traditional investments.
Question 50.1: Compared to traditional investment managers who invest in long-only stocks and bonds, alternative investment managers typically invest in assets that are:
A) less regulated, less transparent, and less liquid.
B) more transparent, less liquid, and less correlated with traditional investments.
C) less transparent, more regulated, and less correlated with traditional investments.
A is correct. Compared to traditional investments, alternative investments exhibit less liquidity, less regulation, and less transparency. As a group, alternative investments generally have relatively low return correlations with traditional investments
LOS 50.b: Compared to traditional investments, alternative investments exhibit less liquidity, less regulation, and less transparency. As a group, alternative investments generally have relatively low return correlations with traditional investments
Question 50.2: Which of the following characteristics most likely applies to private equity investing?
A) Liquid secondary market.
B) High degree of reliance on manager skill.
C) Relatively short-term investment horizon.
B is correct. Returns on private equity investments depend to a large extent on the skill of the general partners. Private equity investments are illiquid and require a long-term investment horizon.
Question 50.3: An equity hedge fund that uses technical analysis techniques to identify undervalued shares to buy and overvalued shares to sell short is best described as pursuing:
A) a market neutral strategy.
B) a special situations strategy.
C) a quantitative directional strategy
C is correct. Quantitative directional strategies employ technical analysis and may have net long or short exposure. A market neutral strategy maintains approximately equal values in long and short positions and is typically based on fundamental analysis. Special situations strategy is an event-driven strategy that involves investing in firms that are selling divisions or assets, distributing capital, or issuing or repurchasing securities.
Question 50.4: An investment in commodities will most likely provide returns from:
A) cash flows from the assets.
B) the yield on collateral deposits.
C) changes in commodity spot prices.
C is correct. Returns from holding commodities depend on changes in spot prices. Investing directly in commodities requires no collateral deposit; this is required for investing in commodity derivatives. Commodities typically do not generate cash flows.
Question 50.5: Compared with purchasing commodities, long positions in commodity derivatives offer the benefit of:
A) no storage costs.
B) convenience yield.
C) better correlation with spot prices.
A is correct. While commodity futures retain the risk and correlation characteristics of the underlying commodities, the investor does not incur storage costs. Derivatives cannot have higher correlation with spot prices than the commodity itself, as its price is the spot price. Convenience yield is a benefit of owning the actual commodities.
LOS 50.d: Describe, calculate, and interpret management and incentive fees and net-of fees returns to hedge funds.
Question 50.6: Arkex Funds is a hedge fund with a value of $100 million at the beginning of the year. Arkex Funds charges a 2.0% management fee based on assets under management at the beginning of the year and a 20.0% incentive fee with a 5.0% hard hurdle rate. Incentive fees are calculated net of management fees. The value of the fund at the end of the year before fees is $110 million. The net return to investors is closest to:
B is correct.
Management fee = $100 million × 2.0% = $2.0 million
Incentive fee = [$110 million − $100 million − $2 million − ($100 million × 5.0%)] × 20% = $0.6 million
Total fee = $2.0 million + $0.6 million = $2.6 million
End-of-year value after fees = $110.0 − $2.60 = $107.4 million
Net return = ($107.4 million / $100.0 million) − 1 = 7.4%.
Question 50.7: A hedge fund that requires incentive fees to be calculated only on the portion of returns above a benchmark return is said to have a:
A) soft hurdle rate.
B) hard hurdle rate.
C) high water mark.
B is correct. In a hedge fund's fee structure, a hard hurdle rate means that incentive fees are earned only on returns in excess of the benchmark return. A soft hurdle rate means that incentive fees are calculated on the entire return, but are only paid if the return exceeds the hurdle rate. A high water mark specifies that incentive fees are only paid on returns that increase an investor's account value above its highest previous value.
LOS 50.f: Describe risk management of alternative investments.
Question 50.8: If a commodity market is in backwardation:
A) it produces a negative roll yield.
B) futures contract prices are less than the spot prices.
C) a long futures position will increase in value as contracts approach expiration.
B is correct. Backwardation means futures prices are less than spot prices or that futures contracts with later expiration dates are priced lower than contracts with earlier expiration dates. This results in a positive roll yield as futures prices converge to the spot prices. This does not
necessarily increase the value of a long position because the spot price may decrease.
Question 50.9: The risk measure for alternative investments that is least likely to be affected by tendency of returns to be leptokurtic is:
A) the Sortino ratio.
B) standard deviation.
C) coefficient of variation.
A is correct. Standard deviation and coefficient of variation, which is based on standard deviation of returns, both may be misleading for alternative investments because their returns distributions tend to be leptokurtic (i.e., they have "fat tails"). The Sortino ratio, in contrast, measures risk as downside deviation from the mean.
Question 50.10: Which of the following is least likely an important element of risk management for alternative investment funds?
A) Setting leverage limits.
B) Obtaining independent valuations of fund positions.
C) Designating a risk management officer who also works as part of the investment team.
C is correct. The risk officer should be separate from those who manage the investment process. Setting leverage limits and getting third party (not in-house) valuations of fund investments are both important elements of risk management for alternative investment funds.
Question 50.11: When conducting due diligence on a vehicle for alternative investments, which of the following observations would most likely be positive for a potential investor?
A) Auditing and reporting to investors are performed by reliable third parties.
B) The general partner is prohibited from commingling his own funds with the limited partners’ funds.
C) A well-known and highly regarded investor holds shares that represent 20% of the vehicle’s assets under management.
A is correct. Use of quality third-party service providers by an investment vehicle is a positive sign for potential investors. Manager and investor interests are more likely to be aligned if the general partner invests alongside the limited partners. If a single investor represents a large
portion of assets under management, and that investor chooses to withdraw, the manager may be forced to liquidate assets at unfavorable prices.
ETHICAL AND PROFESTIONAL STANDARD
Los 2.a: Describe the structure of the CFA Institute Professional Conduct Program and the process for the enforcement of the Code and Standards.
Question 1: Which of the following statements about the CFA Institute's Professional Conduct Program (PCP) is least accurate?
A) Possible sanctions include condemnation by a member’s peers or suspension of a candidate’s participation in the CFA Program.
B) If the PCP staff determine that a sanction against a member is warranted, the member must either accept the sanction or lose the right to use the CFA designation.
C) Members who cooperate with a PCP inquiry by providing confidential client information to PCP staff are not in violation of Standard III(E) Preservation of Confidentiality.
B is correct. Members can accept or reject a disciplinary sanction proposed by the Professional Conduct Program staff. If the member rejects them sanction, the matter is referred to a hearing before a disciplinary review panel of CFA Institute members. The other statements are accurate.
Standard I(B) Independence and Objectivity: Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity
Question 2: Robert Miguel, CFA, is a portfolio manager. On Saturday, one of his clients invited Miguel and his wife to be his guests at his luxury suite for a major league baseball playoff game, which they did. Miguel told his supervisor on Monday that they had attended the game with the client and that the suite was luxurious. Miguel has:
A) not violated the Standards.
B) violated the Standards because disclosure must be in writing.
C) violated the Standards because he must disclose the gift prior to accepting.
A is correct. In this case, Miguel has not violated the standards. For a gift from a client in appreciation of past service or performance, informing his supervisor verbally is sufficient. Standard I(B) Independence and Objectivity requires disclosure prior to accepting the gift "when possible," but in cases such as this when there is short notice, notification afterward is permitted.
Standard II(A) Material nonpublic: Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.
Question 3: While at dinner a member overhears a well-known and influential analyst from a different firm tell his companion that he will be raising his recommendation on Tree Products from hold to buy when he appears on a morning talk show the next day. Before the broadcast, the member buys 1,000 shares of Tree Products for her own account. The member has violated the Standard relating to:
A) fair dealing.
B) diligence and reasonable basis.
C) material nonpublic information.
C is correct. A change in investment recommendation by a well-known and influential analyst is likely to affect the market price and is considered material information, so acting on this information before it has been released is prohibited by Standard II(A) Material Nonpublic.
Standard VI(A) Disclosure of conflicts: Members and Candidates must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, and employer. Members and Candidates must ensure that such disclosures are prominent, are delivered in plain language, and communicate the relevant information effectively
Question 4: Donald Smith, CFA, has been assigned by his employer to write a report for clients on Braden Corporation. Smith has 1,000 shares of Braden that he bought three years ago and has been discussing a consulting contract with Braden to write guidelines for their investor relations department. If Smith writes the report on Braden Corporation, he must disclose within the report:
A) both his ownership of Braden shares and his prospective consulting work.
B) and to his employer his prospective consulting work but not his ownership of Braden shares.
C) his ownership of Braden shares but need only disclose his prospective consulting work to his employer.
A is correct. Both ownership of Braden stock and the possible consulting work present potential conflicts of interest for Smith and must be disclosed within the report to comply with Standard VI(A) Disclosure of Conflicts.
Standard I(C) Misrepresentation: Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.
Question 5: Allen Winkler, CFA, recently had lunch with Kim Thompson, a former professor of his, who told him of a new valuation model she had developed. Winkler recreated Thompson's model with some revisions and back-tested it using data provided by Standard & Poor's (S&P) with impressive results. Winkler's firm launches a mutual fund based on the revised model, and Winkler provides a discussion of the principles underlying the model and the test results. Is Winkler required to credit Thompson for having developed the model and S&P as the source of the data?
A) Both of these sources must be cited.
B) Neither of these sources must be cited.
C) Only one of these sources must be cited.
C is correct. Under Standard I(C) Misrepresentation, Winkler must identify Thompson as having developed the original model to avoid the prohibition against plagiarism. The only permitted exception is using factual information published by recognized financial and statistical reporting services such as S&P.
Standard IV(B) Additional compensation arrangements: Members and Candidates must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved.
Question 6: Ron Brenner, CFA, manages portfolios for individuals. One of his clients, John Perlman, offers Brenner several inducements above those provided by his employer to motivate superior future performance in managing his portfolio. Brenner notifies his manager via email about the terms of this offer, and his employer grants permission. According to the Standard on additional compensation arrangements, Brenner:
A) must notify “all parties involved,” which includes his other clients.
B) has taken all the actions required to accept the arrangement.
C) should decline this arrangement because it could cause partiality in the handling of other client accounts.
B is correct. Brenner's actions comply with the conditions specified in Standard IV(B) Additional Compensation Arrangements. He notified his employer in writing (e-mail is acceptable) of the terms and conditions of additional compensation arrangement and received permission from his employer. Loyalties to other clients may be affected, but it is the employer's duty to determine this. Nothing in the Standard specifies that "all parties involved" includes other clients.
Standard III(E) Preservation of Confidentiality:
Members and Candidates must keep information about current, former, and prospective
clients confidential unless:
1. The information concerns illegal activities on the part of the client;
2. Disclosure is required by law; or
3. The client or prospective client permits disclosure of the information.
Question 7: With respect to a client's confidential information, if a member or candidate believes a client is engaging in illegal activity, the member
should most appropriately:
A) preserve the client’s confidentiality.
B) report the client to the appropriate governmental authorities.
C) seek advice from his firm’s legal counsel or compliance department
C is correct. Guidance for Standard III(E) Preservation of Confidentiality states that members or candidates should seek the advice of compliance personnel or legal counsel about the appropriate actions to take if they suspect illegal activity by clients. Members and candidates must comply with applicable laws, which may require or prohibit disclosure of confidential client information in these circumstances
Standard III(B) Fair dealing: Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.
Question 8: Susan Smart, CFA, is about to change her "buy" recommendation on RollinsCo to "sell." RollinsCo had been growing rapidly over the past year, but Smart believes the growth potential is now gone. Smart sells the shares held in her discretionary client accounts and in her own personal account before issuing her report. According to the Standards that concern fair dealing and priority of transactions, Smart violated:
A) both of these Standards.
B) neither of these Standards.
C) only one of these Standards.
A is correct. Smart violated both Standards. Smart violated Standard III(B) Fair Dealing because she did not deal fairly and objectively with all clients and prospects when disseminating investment recommendations, giving priority to some of the firm's clients by trading for her clients first before issuing the report. She also sold her own shares before issuing the report, which violated Standard VI(B) Priority of Transactions. Smart did not give clients an opportunity to react to and benefit from her recommendation before she personally benefited from her research.
Question 8: An analyst at Romer changes her rating on TelSky from "buy" to "hold" and sends an email explaining the change to all clients and firm brokers. Subsequently, Paul Stevens, CFA, a broker at Romer, receives a call from a client who wants to buy 15,000 shares of TelSky. Stevens must:
A) advise his client of the change in recommendation before accepting the order.
B) not accept the order until the customer has had time to receive and read the new report.
C) accept the order without mentioning the ratings change because the order is unsolicited.
A is correct. According to Standard III(B) Fair Dealing, if a client places an order that goes against the firm's recommendation for that security, members and candidates should inform the client of the discrepancy between the order and the firm's recommendation before accepting the order.
Standard III(A) Loyalty, Prudence and Care: Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.
Question 9: Derek Stevens, CFA, manages the pension plan assets of Colors, Inc. When voting proxies for plan equities, Stevens owes a fiduciary duty to:
A) the plan trustees who hired him.
B) the plan participants and beneficiaries.
C) the managers, stockholders, and bondholders of Colors, Inc., equally
B is correct. Under Standard III(A) Loyalty, Prudence, and Care, the fiduciary duty in this case is to plan participants and beneficiaries, not shareholders or plan trustees.
Standard II(B) Market Manipulation: Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants
Question 10: Edie Pschorr, CFA, notices that a bond is priced at 98.0 in one market and 98.4 in another market. Pschorr places an order to buy a large number of these bonds in the first market and simultaneously places an order to sell the same number of bonds in the second market. The bond's price increases to 98.2 in the first market and decreases to 98.2 in the second market. Are Pschorr's trades a violation of the Code and Standards?
B) Yes, because they violate the Standard concerning fair dealing.
C) Yes, because they violate the Standard concerning market manipulation.
A is correct. The trader has carried out an arbitrage transaction. Because she did not exhibit any intent to distort prices or trading volume, the member did not violate Standard II(B) Market Manipulation. Standard III(B) Fair Dealing is concerned with fair treatment of clients and is not relevant to this transaction.
LOS 5.a: Describe the key features of the GIPS standards and the fundamentals of compliance
Question 11: When calculating the performance of a composite, which of the following actions complies with GIPS?
A) Defining a composite so as to include portfolios that have been discontinued.
B) Assigning each portfolio to a single composite at the end of the year based on its holdings over the year.
C) Calculating a composite’s return as the mean annual total return of portfolios assigned to the composite.
A is correct. GIPS require discontinued portfolios to be included in composites. To comply with GIPS, portfolios must be assigned to composites before the returns are known; assigning them at the end of the year is not acceptable. The composite return must be asset weighted,not a simple average (equal-weighted).