Alt Inv. Flashcards
Q: What distinguishes alternative investments from traditional investments?
A: Alternative investments include hedge funds, private equity, and real estate, differing from traditional long-only investments in publicly traded stocks and bonds. They are typically actively managed, may include illiquid securities, and often have low correlations with traditional assets.
Q: What are the key characteristics of alternative investments?
A: Alternative investments typically require specialized knowledge, exhibit low correlations with traditional assets, have less liquidity, longer investment horizons, and require larger capital commitments.
Q: What are the two main types of private capital investments?
A: Private capital consists of private equity and private debt. Private equity includes leveraged buyouts (LBOs) and venture capital, while private debt involves direct lending, venture debt, or distressed debt investments.
Q: What are some examples of real assets in alternative investments?
A: Real assets include real estate, infrastructure (e.g., roads, airports), natural resources (e.g., commodities, farmland, timberland), and other assets such as collectibles, patents, and digital assets.
Q: How do fund investment, co-investment, and direct investment differ?
A:
Fund Investment: Investors pool money into a fund managed by a professional.
Co-Investment: Investors contribute to a fund but also invest directly alongside the fund manager in select assets.
Direct Investment: Investors purchase assets themselves without a fund manager.
Q: How are fund managers typically compensated in alternative investments?
A: Fund managers earn a management fee (1-2% of assets) and a performance fee (typically 20% of profits, often with a hurdle rate). Some structures include high-water marks, catch-up clauses, and clawback provisions to align interests between investors and managers.
Compared with alternative investments, traditional investments tend to:
A)
be less liquid.
B)
have lower fees.
C)
require more specialized knowledge.
Explanation
Traditional investments typically have lower fees, require less specialized knowledge by investment managers, and are more liquid than alternative investments. (Module 76.1, LOS 76.a)
An investor who wants to gain exposure to alternative investments but does not have the in-house expertise to perform due diligence on individual deals is most likely to engage in:
A)
co-investing.
B)
fund investing.
C)
direct investing.
Explanation
With fund investing, due diligence on the fund’s portfolio investments is a responsibility of the fund manager rather than the fund investors. Direct investing and co-investing require greater due diligence of individual deals on the part of the investor. (Module 76.1, LOS 76.b)
For an investor in a private equity fund, the least advantageous of the following limited partnership terms is a(n):
A)
clawback provision.
B)
European-style waterfall provision.
C)
American-style waterfall provision.
Explanation
An American-style waterfall structure has a deal-by-deal calculation of incentive fees to the GP. In this case, a successful deal where incentive fees are paid, followed by the sale of a holding that has losses in the same year, can result in incentive fees greater than those calculated using a European-style (whole-of-fund) waterfall. A clawback provision benefits the limited partners by allowing them to recover performance fees paid earlier if the fund realizes losses later. A clawback provision, coupled with an American-style waterfall, will result in the same overall performance fees as a European-style waterfall if the transactions occur in subsequent years. (Module 76.1, LOS 76.c)
Q: What are the key risks associated with alternative investments?
A: Timing of cash flows, use of leverage, valuation challenges, and complex fee structures.
Q: What are the three phases of the alternative investment life cycle?
A: 1) Capital commitment phase (negative returns due to capital outflows), 2) Capital deployment phase (continued negative returns as investments develop), 3) Capital distribution phase (positive returns as investments generate cash flows).
Q: What is the J-curve effect in alternative investments?
A: A pattern where returns are negative in early phases (capital commitment and deployment) and increase in the later capital distribution phase.
Q: Why is IRR the most appropriate measure of after-tax investment performance for alternative
investments?
A: Because IRR (a money-weighted rate of return) accounts for the timing and magnitude of cash flows, which managers control.
Q: How does leverage impact alternative investment returns?
A: It magnifies gains and losses, can lead to margin calls, and may result in forced liquidations at unfavorable prices.
Q: What are the three levels of fair value hierarchy for alternative investments?
A: Level 1: Quoted market prices, Level 2: Valuations based on observable inputs, Level 3: Valuations based on unobservable inputs (e.g., private equity).
Q: How can fee structures affect alternative investment returns?
A: Fees vary by investor and can include management fees, performance fees (with hurdles or high-water marks), and redemption restrictions like lockups and gates.
Q: What biases can affect reported alternative investment returns?
A: Survivorship bias (excluding failed funds) and backfill bias (including only successful historical returns), leading to overstated performance.
Q: What is private capital?
A: Private capital is funding provided to companies that is not raised from public markets. It includes private equity and private debt.
Q: What is a leveraged buyout (LBO) in private equity?
A: An LBO is when a private equity firm acquires a public company using a large percentage of debt, taking it private to improve operations and increase value
Q: What are the stages of venture capital (VC) investment?
A: VC investment stages include pre-seed (angel investing), seed-stage, early-stage, later-stage (expansion), and mezzanine-stage (pre-IPO financing).
Q: What are the main private equity exit strategies?
A: Exit strategies include trade sale, public listing (IPO, direct listing, SPAC), recapitalization, secondary sale, and write-off/liquidation.
Q: What are the main types of private debt?
A: Private debt includes direct lending, venture debt, mezzanine debt, distressed debt, and unitranche debt, each with different risk and return profiles.
Q: How does private capital provide diversification benefits?
A: Private capital has lower correlation with public markets (0.63-0.83), reducing portfolio risk. Diversifying across vintage years and business cycles improves returns.
Q: What are the two primary ways to invest in real estate?
A: Real estate investment can be made directly by purchasing properties or indirectly through limited partnerships and publicly traded securities like REITs.
Q: What are the two dimensions of real estate investment classification?
A: Investments are classified by (1) public vs. private real estate and (2) equity vs. debt ownership.
Q: What are the benefits and drawbacks of direct real estate investment?
A: Benefits: Control, diversification, tax advantages.
Drawbacks: Illiquidity, high capital requirements, management complexity, market knowledge required.
Q: What are the main types of REIT investment strategies?
A: - Core: Stable income from high-quality properties (low risk).
Core-plus: Modest redevelopment (moderate risk).
Value-add: Larger-scale redevelopment (higher risk).
Opportunistic: High-risk investments in distressed or speculative properties
Q: How do REITs compare to direct real estate investments in terms of diversification and risk?
A: REITs provide greater diversification and liquidity but have higher correlation with equities, especially during market downturns.
Which of the following is most likely an advantage of direct real estate investment as compared to investing in a REIT?
A)
Diversification within the asset class.
B)
Higher liquidity.
C)
Greater control.
Explanation
Direct investments tend to have lower diversification within the asset class (concentration risk), lower liquidity, but greater control (deciding on which property to invest/develop/sell) relative to investment in REITs. (Module 79.1, LOS 79.a)
Which of the following real estate investment strategies is less risky than a core real estate strategy?
A)
First mortgage debt.
B)
Core-plus strategies.
C)
Opportunistic strategies.
Explanation
The risk levels (lowest to highest) are senior debt, core strategies, core-plus strategies, value-add strategies, and opportunistic strategies. (Module 79.1, LOS 79.b)
Q: What are the main categories of infrastructure investments?
A: 1. Transportation (e.g., roads, airports, ports, railways)
2. Utilities (e.g., gas, electricity, waste management)
3. Information & Communication Technology (e.g., telecom towers, cable systems)
4. Social Infrastructure (e.g., schools, hospitals, prisons)
Q: What are the different types of infrastructure investments?
A: - Greenfield investments: New projects that follow a build-operate-transfer (BOT) model.
Brownfield investments: Expansion or privatization of existing infrastructure.
Secondary-stage investments: Fully operational assets requiring no further development.
Q: What are the key investment characteristics of infrastructure assets?
A: - Stable cash flows due to long-term contracts and barriers to entry.
Low correlation with public equities, providing diversification.
Infrastructure debt is generally safer and less cyclical.
Greenfield investments have more uncertainty but higher growth potential.
Regulatory, financial leverage, construction, and operational risks must be considered.
Q: Who are the typical investors in infrastructure assets?
A: Long-term institutional investors, such as pension plans, life insurance companies, and sovereign wealth funds, due to the stable and long-duration nature of infrastructure investments.
Which of the following infrastructure investments provides the greatest degree of certainty about cash flows?
A)
Secondary-stage investments.
B)
Sale and leaseback arrangements.
C)
Greenfield investments.
Explanation
Secondary-stage investments are brownfield investments that are fully operational, do not require further investment, and generate predictable periodic cash flows. Other brownfield investments, such as the privatization of public assets or sale and leaseback arrangements, may have a short operating history and uncertainty of cash flows. Greenfield investments tend to be the most risky, requiring development of new assets with uncertain cash flows. (Module 79.2, LOS 79.c)
Which of the following infrastructure projects is most likely to offer the highest expected return?
A)
First-lien mortgage on an existing toll road.
B)
Equity investment in a new airport in a developed country.
C)
Equity investment in a new passenger rail line in a developing country.
Explanation
Projects that are most risky would generally have the highest expected returns. A new rail line in a developing country is a greenfield investment. Greenfield investments in developing economies, while risky, have generated attractive returns over the long term as per-capita incomes and wealth increase. An existing toll road is a brownfield investment, the debt of which is likely to be less risky and therefore offer a lower expected return. A greenfield investment in a developed country would most likely be in the middle of risk and return profile of the other two choices. (Module 79.2, LOS 79.d)
Q: What are the main categories of natural resource investments?
A: - Raw land (undeveloped land)
Farmland (used for crops)
Timberland (forests for wood production)
Commodities (e.g., metals, agricultural products, energy)
Investments can be direct (owning land/commodities) or indirect (ETFs, REITs, limited partnerships, derivatives).
Q: What are the key differences between greenfield and brownfield infrastructure investments?
A: - Greenfield investments: New projects with high growth potential but greater uncertainty (e.g., new toll roads, renewable energy projects).
Brownfield investments: Expansion or privatization of existing assets, offering stable cash flows and lower risk (e.g., existing toll roads, hospitals).
Secondary-stage investments: Fully operational assets with little to no further development required.
Q: What are the key characteristics of commodities as an investment?
A: - Three major sectors: Metals, agriculture, and energy.
Investment methods: Direct ownership, commodity derivatives (futures, forwards, swaps), ETFs, managed futures, and specialized funds.
Storage costs: Physical commodities incur storage, insurance, and transportation costs.
Government influence: Regulations, subsidies, and geopolitical risks affect commodity prices.
Q: How do commodity prices and returns behave?
A: - Determined by supply and demand: Supply is often inelastic in the short term, leading to volatility.
Short-term risks: Weather, natural disasters, production constraints, and government policy.
Diversification benefits: Low correlation with stocks and bonds, making commodities useful for portfolio diversification.
Inflation hedge: Commodity prices tend to rise with inflation, outperforming traditional assets during high inflation periods.
Which of the following is least likely when net cost of carry for a commodity is negative?
A)
Futures prices will be in backwardation.
B)
Futures prices will be in contango.
C)
Long-only investors will generally earn a higher return.
Explanation
When the cost of carry is negative, futures prices will be lower than the spot prices, which is called backwardation. Under backwardation, long-only investors will generally earn a higher return. (Module 80.1, LOS 80.b)
Which of the following is least accurate about commodity returns?
A)
Returns and volatility have been higher for commodities than for stocks or bonds.
B)
Timberland and farmland returns have lower volatility as compared to global stock returns.
C)
Because commodity prices tend to have negative correlation with inflation rates, holding commodities can act as a hedge of inflation risk
Correct Answer
Explanation
Because commodity prices tend to move with inflation rates (positive correlation), holding commodities can act as a hedge of inflation risk. (Module 80.1, LOS 80.c)
Q: What are hedge funds, and how do they differ from mutual funds?
A: Hedge funds are private pooled investment vehicles available to accredited investors. Unlike mutual funds, they are lightly regulated, have flexible strategies, and use leverage and derivatives.
Q: What are some common hedge fund categories and strategies?
A: Categories include equity hedge (e.g., long/short, market neutral), event-driven
Q: What are the two main ways to invest in natural resources?
A: Direct investment (e.g., owning land or commodities) and indirect investment via commingled funds (e.g., ETFs, REITs, partnerships, LLCs, and derivatives like futures and swaps).
Q: What are the key factors that influence the value of raw land, farmland, and timberland?
A: Location, proximity to transportation and markets, access to water, and soil quality.
Q: What is the relationship between futures prices and spot prices in commodities?
A: Futures price ≈ Spot price × (1 + risk-free rate) + storage costs − convenience yield. When futures prices are higher than spot prices, it’s called contango; when lower, it’s called backwardation.
Q: Why are commodities considered a good hedge against inflation?
A: Commodity prices tend to move with inflation, outperforming stocks and bonds during high inflation periods and underperforming during low inflation.
Q: How do hedge funds differ from mutual funds and private equity funds?
A: Hedge funds are less regulated, use leverage and derivatives, focus on absolute returns, and have shorter time horizons than private equity funds.
Q: What are the four main categories of hedge fund strategies?
A:
Equity hedge (long/short, value, growth, market-neutral, short bias)
Event-driven (merger arbitrage, distressed, activist, special situations)
Relative value (convertible arbitrage, fixed income arbitrage)
Opportunistic (macro, managed futures)
An institutional investor who wants to invest in a hedge fund that engages in convertible bond arbitrage would most appropriately select a:
A)
relative value strategy fund
B)
special situation fund.
C)
separately managed account.
Explanation
Convertible bond arbitrage is an example of a relative value strategy. Institutional investors may choose a separately managed account if their investment allocation is large and if they want custom funds to align with the institution’s risk/return objectives. A special situation fund would be an equity investment strategy focusing on companies undertaking issuance/ repurchase or other similar capital market transactions.
An investor who chooses a fund-of-funds as an alternative to a single hedge fund is most likely to benefit from:
A)
lower fees.
B)
higher returns.
C)
manager expertise.
Explanation
A fund-of-funds manager is expected to provide expertise in selecting hedge funds. Funds-of-funds charge fees in addition to those charged by the funds in which they invest. Investing in funds-of-funds may provide more diversification, but it may not necessarily provide higher returns, due in part to the additional layer of fees.
Hedge funds use leverage to magnify which of the following?
A)
Alpha.
B)
Market beta.
C)
Currency risk.
Explanation
Fund managers seek to magnify sector beta and alpha by using leverage. Hedge funds seek to reduce risks and often remove market beta exposure with short positions.
Q: What are digital assets, and how are they secured?
A: Digital assets are electronically created, stored, and transferred assets, including cryptocurrencies, tokens, and digital collectibles. They are secured and validated using distributed ledger technology (DLT), also known as blockchain.
Q: What are the key advantages and disadvantages of distributed ledger technology (DLT)?
A:
Advantages: Accuracy, transparency, security, rapid ownership transfer, and peer-to-peer (P2P) interactions.
Disadvantages: Data protection concerns, potential privacy violations, and high computational power requirements.
Q: How do proof of work (PoW) and proof of stake (PoS) consensus protocols differ?
A:
PoW: Miners solve cryptographic problems to validate transactions, requiring high computational power.
PoS: Validators stake collateral to confirm transactions, reducing energy use compared to PoW
Q: What is the difference between permissionless and permissioned DLT networks?
A:
Permissionless: Open to all users, transactions are validated by consensus mechanisms (e.g., Bitcoin).
Permissioned: Access is restricted; certain users have different levels of permissions for security and efficiency.
Q: What are stablecoins, and how do they maintain value?
A: Stablecoins are digital currencies pegged to an asset (e.g., USD) and backed by a reserve. Algorithmic stablecoins maintain price stability through supply adjustments.
Q: What is tokenization, and how do NFTs and security tokens differ?
A: Tokenization digitizes asset ownership using DLT.
NFTs: Represent unique digital assets like art.
Security tokens: Digitally track ownership of publicly traded securities.
Front: What are some reasons institutional investors are increasingly interested in digital assets?
Back: Institutional investors are drawn to digital assets due to high expected returns and diversification benefits. Financial service providers have also strengthened their infrastructure to support future institutional investment.
Front: How do digital assets differ from traditional financial assets in terms of inherent value?
Back: Most digital assets are not backed by underlying assets or cash flows (e.g., interest or dividends). Instead, their prices are based on projected asset growth, scarcity, and their ability to transfer value in the future.
Front: What are the key risks of direct cryptocurrency investment?
Back: Risks include fraud (e.g., scam ICOs, pump-and-dump schemes), theft, wallet credential loss, market manipulation by “whales,” and regulatory uncertainty. Losing a wallet passkey can render holdings worthless.
Front: What are the main differences between centralized and decentralized cryptocurrency exchanges?
Back:
Centralized exchanges provide price transparency but rely on private servers, which pose security risks and may be regulated.
Decentralized exchanges operate on a distributed framework, making them harder to regulate but more resilient to attacks.
Front: How do cryptocurrencies impact portfolio diversification?
Back: Historically, cryptocurrencies have shown low correlation with traditional asset classes, offering potential diversification benefits. However, correlations may increase during periods of extreme market stress.
Front: What is DeFi, and how does it relate to asset-backed tokens?
Back: Decentralized finance (DeFi) aims to create financial products and services using open-source applications. Asset-backed tokens represent digital ownership of physical or financial assets, improving liquidity and transparency.
