Alternative Investments

Question 1

Which of the following is least likely to be considered an alternative
investment?
A Real estate
B Commodities
C Long- only equity funds

Answer 1

C is correct. Long- only equity funds are typically considered traditional investments
and real estate and commodities are typically classified as alternative
investments.

Question 2

Private equity funds are most likely to use:
A merger arbitrage strategies.
B leveraged buyouts.
C market- neutral strategies.

Answer 2

B is correct. The majority of private equity activity involves leveraged buyouts.
Merger arbitrage and market neutral are strategies used by hedge funds.

Question 3

An investor is seeking an investment that can take long and short positions,
may use multi- strategies, and historically exhibits low correlation with a traditional
investment portfolio. The investor’s goals will be best satisfied with an
investment in:
A real estate.
B a hedge fund.
C a private equity fund.

Answer 3

B is correct. Hedge funds may use a variety of strategies (event- driven, relative
value, macro and equity hedge), generally have a low correlation with traditional
investments, and may take long and short positions.

Question 4

Relative to traditional investments, alternative investments are least likely to be
characterized by:
A high levels of transparency.
B limited historical return data.
C significant restrictions on redemptions.

Answer 4

A is correct. Alternative investments are characterized as typically having low
levels of transparency

Question 5

Alternative investment funds are typically managed:
A actively.
B to generate positive beta return.
C assuming that markets are efficient.

Answer 5

A is correct. There are many approaches to managing alternative investment
funds but typically these funds are actively managed.

Question 6

Compared with traditional investments, alternative investments are more likely
to have:
A greater use of leverage.
B long- only positions in liquid assets.
C more transparent and reliable risk and return data.

Answer 6

A is correct. Investing in alternative investments is often pursued through such
special vehicles as hedge funds and private equity funds, which have flexibility
to use leverage. Alternative investments include investments in such assets as
real estate, which is an illiquid asset, and investments in such special vehicles
as private equity and hedge funds, which may make investments in illiquid
assets and take short positions. Obtaining information on strategies used and
identifying reliable measures of risk and return are challenges of investing in
alternatives.

Question 7

The potential benefits of allocating a portion of a portfolio to alternative investments
include:
A ease of manager selection.
B improvement in the portfolio’s risk–return relationship.
C accessible and reliable measures of risk and return.

Answer 7

B is correct. Adding alternative investments to a portfolio may provide diversification
benefits because of these investments’ less than perfect correlation
with other assets in the portfolio. As a result, allocating a portion of one’s funds
to alternatives could potentially result in an improved risk–return relationship.
Challenges to allocating a portion of a portfolio to alternative investments
include obtaining reliable measures of risk and return as well as selecting portfolio
managers for the alternative investments.

Question 8

An investor may prefer a single hedge fund to a fund of funds if he seeks:
A due diligence expertise.
B better redemption terms.
C a less complex fee structure.

Answer 8

C is correct. Hedge funds of funds have multi- layered fee structures, while the
fee structure for a single hedge fund is less complex. Funds of funds presumably
have some expertise in conducting due diligence on hedge funds and may
be able to negotiate more favorable redemption terms than could an individual
investor in a single hedge fund.

Question 9

Hedge funds are similar to private equity funds in that both:
A are typically structured as partnerships.
B assess management fees based on assets under management.
C do not earn an incentive fee until the initial investment is repaid.

Answer 9

A is correct. Private equity funds and hedge funds are typically structured
as partnerships where investors are limited partners (LP) and the fund is the
general partner (GP). The management fee for private equity funds is based on
committed capital whereas for hedge funds the management fees are based on
assets under management. For most private equity funds, the general partner
does not earn an incentive fee until the limited partners have received their
initial investment back.

Question 10

An investor seeks a current income stream as a component of total return,
and desires an investment that historically has low correlation with other asset
classes. The investment most likely to achieve the investor’s goals is:
A timberland.
B collectibles.
C commodities.

Answer 10

A is correct. Timberland offers an income stream based on the sale of timber
products as a component of total return and has historically generated returns
not highly correlated with other asset classes.

Question 11

Both event- driven and macro hedge fund strategies use:
A long–short positions.
B a top- down approach.
C long- term market cycles.

Answer 11

A is correct. Long–short positions are used by both types of hedge funds to
potentially profit from anticipated market or security moves. Event- driven
strategies use a bottom- up approach and seek to profit from short- term events
typically involving a corporate action, such as an acquisition or a restructuring.
Macro strategies seek to profit from expected movements in evolving economic
variables.

Question 12

Hedge fund losses are most likely to be magnified by a:
A margin call.
B lockup period.
C redemption notice period.

Answer 12

A is correct. Margin calls can magnify losses. To meet the margin call, the
hedge fund manager may be forced to liquidate a losing position in a security,
which, depending on the position size, could exert further price pressure on the
security, resulting in further losses. Restrictions on redemptions, such as lockup
and notice periods, may allow the manager to close positions in a more orderly
manner and minimize forced- sale liquidations of losing positions.

Question 13

The first stage of financing at which a venture capital fund most likely invests is
the:
A seed stage.
B mezzanine stage.
C angel investing stage.

Answer 13

A is correct. The seed stage supports market research and product development
and is generally the first stage at which venture capital funds invest. The seed
stage follows the angel investing stage. In the angel investing stage, funds are
typically provided by individuals (often friends or family), rather than a venture
capital fund, to assess an idea’s potential and to transform the idea into a plan.
Mezzanine- stage financing is provided by venture capital funds to prepare the
portfolio company for its IPO.

Question 14

What is the most significant drawback of a repeat sales index to measure
returns to real estate?
A Sample selection bias
B Understatement of volatility
C Reliance on subjective appraisals

Answer 14

A is correct. A repeat sales index uses the changes in price of repeat- sale properties
to construct the index. Sample selection bias is a significant drawback
because the properties that sell in each period vary and may not be representative
of the overall market the index is meant to cover. The properties that transact
are not a random sample and may be biased toward properties that changed
in value. Understated volatility and reliance on subjective appraisals by experts
are drawbacks of an appraisal index.

Question 15

Compared with direct investment in infrastructure, publicly traded infrastructure
securities are characterized by:
A higher concentration risk.
B more- transparent governance.
C greater control over the infrastructure assets.

Answer 15

B is correct. Publicly traded infrastructure securities, which include shares
of companies, exchange- traded funds, and listed funds that invest in infrastructure,
provide the benefits of transparent governance, liquidity, reasonable
fees, market prices, and the ability to diversify across underlying assets. Direct
investment in infrastructure involves a large capital investment in any single
project, resulting in high concentration risks. Direct investment in infrastructure
provides control over the assets and the opportunity to capture the assets’
full value.

Question 16

An equity hedge fund following a fundamental growth strategy uses fundamental
analysis to identify companies that are most likely to:
A be undervalued.
B be either undervalued or overvalued.
C experience high growth and capital appreciation.

Answer 16

C is correct. Fundamental growth strategies take long positions in companies
identified, using fundamental analysis, to have high growth and capital appreciation.
Fundamental value strategies use fundamental analysis to identify undervalued
companies. Market- neutral strategies use quantitative and/or fundamental
analysis to identify under- and overvalued companies.

Question 17

Which of the following is most likely to be available when conducting hedge
fund due diligence?
A The benchmark used by the fund
B Information on systems risk management
C Details of investment strategies and processes

Answer 17

A is correct. It should be possible to identify the benchmark against which the
fund gauges its performance in the hedge fund due diligence process. It should
also be possible to establish the range of markets in which the fund invests
as well as the fund’s general strategy. Hedge funds consider their strategies,
systems, and processes to be proprietary and are unwilling to provide much
information to potential investors.

Question 18

A private equity fund desiring to realize an immediate and complete cash exit
from a portfolio company is most likely to pursue a(n):
A IPO.
B trade sale
C recapitalization.

Answer 18

B is correct. Private equity funds can realize an immediate cash exit in a trade
sale. Using this strategy, the portfolio company is typically sold to a strategic
buyer.

Question 19

As the loan- to- value ratio increases for a real estate investment, risk most likely
increases for:
A debt investors only.
B equity investors only.
C both debt and equity investors.

Answer 19

C is correct. The higher the loan- to- value ratio, the higher leverage is for a real
estate investment, which increases the risk to both debt and equity investors.

Question 20

Which of the following forms of infrastructure investments is the most liquid?
A An unlisted infrastructure mutual fund
B A direct investment in a greenfield project
C An exchange- traded master limited partnership (MLP)

Answer 20

C is correct. A publicly traded infrastructure security, such as an exchangetraded
MLP, provides the benefit of liquidity.

Question 21

An investor chooses to invest in a brownfield rather than a greenfield infrastructure
project. The investor is most likely motivated by:
A growth opportunities.
B predictable cash flows.
C higher expected returns.

Answer 21

B is correct. A brownfield investment is an investment in an existing infrastructure
asset, which is more likely to have a history of steady cash flows compared
with that of a greenfield investment. Growth opportunities and returns are
expected to be lower for brownfield investments, which are less risky than
greenfield investments.

Question 22

The privatization of an existing hospital is best described as:
A a greenfield investment.
B a brownfield investment.
C an economic infrastructure investment.

Answer 22

B is correct. Investing in an existing infrastructure asset with the intent to
privatize, lease, or sell and lease back the asset is referred to as a brownfield
investment. An economic infrastructure asset supports economic activity and
includes such assets as transportation and utility assets. Hospitals are social
infrastructure assets, which are focused on human activities.

Question 23

A hedge fund invests primarily in distressed debt. Quoted market prices are
available for the underlying holdings but they trade infrequently. Which of the
following will the hedge fund most likely use in calculating net asset value for
trading purposes?
A Average quotes
B Average quotes adjusted for liquidity
C Bid prices for short positions and ask prices for long positions

Answer 23

B is correct. Many practitioners believe that liquidity discounts are necessary to
reflect fair value. This has resulted in some funds having two NAVs - for trading
and reporting. The fund may use average quotes for reporting purposes but
apply liquidity discounts for trading purposes.

Question 24

Angel investing capital is typically provided in which stage of financing?
A Later- stage.
B Formative- stage.
C Mezzanine- stage.

Answer 24

B is correct. Formative- stage financing occurs when the company is still in the
process of being formed and encompasses several financing steps. Angel investing
capital is typically raised in this early stage of financing.

Question 25

If a commodity’s forward curve is in contango, the component of a commodities
futures return most likely to reflect this is:
A spot prices.
B the roll yield.
C the collateral yield.

Answer 25

B is correct. Roll yield refers to the difference between the spot price of a commodity
and the price specified by its futures contract (or the difference between
two futures contracts with different expiration dates). When futures prices are
higher than the spot price, the commodity forward curve is upward sloping, and
the prices are referred to as being in contango. Contango occurs when there is
little or no convenience yield.

Question 26

United Capital is a hedge fund with $250 million of initial capital. United
charges a 2% management fee based on assets under management at year end,
and a 20% incentive fee based on returns in excess of an 8% hurdle rate. In its
first year, United appreciates 16%. Assume management fees are calculated
using end- of- period valuation. The investor’s net return assuming the performance
fee is calculated net of the management fee is closest to:
A 11.58%.
B 12.54%.
C 12.80%.

Answer 26

B is correct. The net investor return is 12.54%, calculated as:
End of year capital = $250 million × 1.16 = $290 million
Management fee = $290 million × 2% = $5.8 million
Hurdle amount = 8% of $250 million = $20 million;
Incentive fee = ($290 − $250 − $20 − $5.8) million × 20% = $2.84 million
Total fees to United Capital = ($5.8 + $2.84) million = $8.64 million
Investor net return: ($290 − $250 − $8.64) / $250 = 12.54%

Question 27

Capricorn Fund of Funds invests GBP 100 million in each of Alpha Hedge
Fund and ABC Hedge Fund. Capricorn FOF has a “1 and 10” fee structure.
Management fees and incentive fees are calculated independently at the end
of each year. After one year, net of their respective management and incentive
fees, the investment in Alpha is valued at GBP80 million and the investment
in ABC is valued at GBP140 million. The annual return to an investor in
Capricorn, net of fees assessed at the fund of funds level, is closest to:
A 7.9%.
B 8.0%.
C 8.1%.

Answer 27

A is correct because the net investor return is 7.9%, calculated as:
First, note that “1 and 10” refers to a 1% management fee, and a 10% incentive
fee.
End of year capital = GBP140 million + GBP80 million = GBP220 million
Management fee = GBP220 million × 1% = GBP2.2 million
Incentive fee = (GBP220 − GBP200) million × 10% = GBP2 million
Total fees to Capricorn = (GBP2.2 + GBP2) million = GBP4.2 million
Investor net return: (GBP220 − GBP200 − GBP4.2) / GBP200 = 7.9%

Question 28

The following information applies to Rotunda Advisors, a hedge fund:
● $288 million in assets under management (AUM) as of prior year-e nd
● 2% management fee (based on year-e nd AUM)
● 20% incentive fee calculated:
■ net of management fee
■ using a 5% soft hurdle rate
■ using a high- water mark (high- water mark is $357 million)
● Current year fund return is 25%
The total fee earned by Rotunda in the current year is closest to:
A $7.20 million.
B $20.16 million.
C $21.60 million.

Answer 28

A is correct. Rotunda earns a management fee of $7.20 million but does not
earn an incentive fee because the year- end fund value net of management fee
does not exceed the high- water mark of $357 million.
Rotunda fees:
End- of- year AUM = Prior year- end AUM × (1 + Fund return) = $288 million
× 1.25 = $360 million
$360 million × 2% = $7.20 million management fee
$360 million – $7.2 million = $352.8 million AUM net of management fee
The year- end AUM net of fees does not exceed the $357 million high- water
mark. Therefore, no incentive fee is earned.

Question 29

A hedge fund has the following fee structure:
Annual management fee based on year- end AUM 2%
Incentive fee 20%
Hurdle rate before incentive fee collection starts 4%
Current high- water mark $610 million
The fund has a value of $583.1 million at the beginning of the year. After one
year, it has a value of $642 million before fees. The net return to an investor for
this year is closest to:
A 6.72%.
B 6.80%.
C 7.64%.

Answer 29

C is correct. The management fee for the year is
$642 × 0.02 = $12.84 million.
Because the ending value exceeds the high- water mark, the hedge fund can
collect an incentive fee. The incentive fee is
{$642 – [$610 × (1 + 0.04)]} × 0.20 = $1.52 million.
The net return to the investor for the year is
[($642 – $12.84 – $1.52)/$583.1] – 1 ≈ 0.07638 ≈ 7.64%.

Question 30

Ash Lawn Partners, a fund of hedge funds, has the following fee structure:
● 2/20 underlying fund fees with incentive fees calculated independently
● Ash Lawn fees are calculated net of all underlying fund fees
● 1% management fee (based on year-e nd market value)
● 10% incentive fee calculated net of management fee
● The fund and all underlying funds have no hurdle rate or high-w ater mark
fee conditions
In the latest year, Ash Lawn’s fund value increased from $100 million to
$133 million before deduction of management and incentive fees of the fund or
underlying funds. Based on the information provided, the total fee earned by all
funds in the aggregate is closest to:
A $11.85 million.
© CFA Institute. For candidate use only. Not for distribution.
Practice Problems 69
B $12.75 million.
C $12.87 million.

Answer 30

B is correct. Total fees paid to all funds (underlying funds and Ash Lawn) are
$12.75 million, consisting of underlying fund fees of $9.26 million and Ash
Lawn fees of $3.49 million, calculated as follows:
Underlying fund fees:
Management fee = $133 million × 0.02 = $2.66 million.
Incentive fee = ($133 – $100) million × 0.20 = $6.60 million.
Total underlying fund fees ($2.66 + $6.60) million = $9.26 million.
Ash Lawn fees:
AUM at end of year, net of underlying fund fees = $133 million – $9.26 million
= $123.74 million.
Ash Lawn management fee = $123.74 million × 0.01 = $1.24 million
(rounded).
AUM net of underlying fund fees and Ash Lawn management fee = ($123.74
– $1.24) million = $122.50 million (rounded).
Ash Lawn incentive fee = ($122.50 – $100) million × 0.10 = $2.25 million
(rounded).
Total Ash Lawn fees = ($1.24 + $2.25) million = $3.49 million (rounded).
Total fees of underlying funds and Ash Lawn:
($9.26 + $3.49) million = $12.75 million (rounded).

Question 31

Risks in infrastructure investing are most likely greatest when the project
involves:
A construction of infrastructure assets.
B investment in existing infrastructure assets.
C investing in assets that will be leased back to a government.

Answer 31

A is correct. Infrastructure projects involving construction have more risk than
investments in existing assets with a demonstrated cash flow or investments in
assets that are expected to generate regular cash flows because the assets will be
leased back to a government.

Question 32

An investor in a private equity fund is concerned that the general partner can
receive incentive fees in excess of the agreed- on incentive fees by making distributions
over time based on profits earned rather than making distributions only
at exit from investments of the fund. Which of the following is most likey to
protect the investor from the general partner receiving excess fees?
A A high hurdle rate
B A clawback provision
C A lower capital commitment

Answer 32

B is correct. A clawback provision requires the general partner in a private
equity fund to return any funds distributed (to the general partner) as incentive
fees until the limited partners have received back their initial investments
and the contracted portion of the total profits. A high hurdle rate will result in
distributions occurring only after the fund achieves a specified return. A high
hurdle rate decreases the likelihood of, but does not prevent, excess distributions.
Management fees, not incentive fees, are based on committed capital.

Question 33

Until the committed capital is fully drawn down and invested, the management
fee for a private equity fund is based on:
A invested capital.
B committed capital.
C assets under management.

Answer 33

B is correct. Until the committed capital is fully drawn down and invested, the
management fee for a private equity fund is based on committed capital, not
invested capital.

Question 34

An analyst wanting to assess the downside risk of an alternative investment is
least likely to use the investment’s:
A Sortino ratio.
B value at risk (VaR).
C standard deviation of returns.

Answer 34

C is correct. Downside risk measures focus on the left side of the return distribution
curve where losses occur. The standard deviation of returns assumes that
returns are normally distributed. Many alternative investments do not exhibit close- to- normal distribution of returns, which is a crucial assumption for the
validity of a standard deviation as a comprehensive risk measure. Assuming
normal probability distributions when calculating these measures will lead to an
underestimation of downside risk for a negatively skewed distribution. Both the
Sortino ratio and the value- at- risk measure are both measures of downside risk.

Question 35

An effective risk management process used by alternative investment funds
most likely includes:
A in- house valuations.
B internal custody of assets.
C segregation of risk and investment process duties.

Answer 35

C is correct. Investment risk should be monitored by a chief risk officer who is
separated from the investment process. Risk factors monitored include leverage,
sector, and individual position limits as well as counterparty risks. Independent
(as opposed to in- house) valuation of underlying positions should be performed
and reviewed on a regular basis. Third- party custody of assets can help reduce
the chance of fraud.

Question 36

Which of the following statements is least correct? In addition to management fees, a leveraged
buyout (LBO) firm may also charge:
A. incentive fees.
B. underwriting fees.
C. a fee if the deal falls through.

Answer 36

Answer: B
This is incorrect as underwriting fees are generally paid to investment banks in issuing new
securities, not by an LBO firm that is taking a company private.

Question 37

Missy Cohen, CFA, is a portfolio manager for a small hedge fund based in Phoenix, Arizona.
Using internally developed data sets and models, Cohen looks to invest in the securities of
companies that are engaged in restructuring activities. The type of hedge fund strategy employed
by Cohen is best described as:
A. macro
B. event-driven
C. relative value

Answer 37

Answer: B
This is correct. Cohen is specifically focused on companies going through certain “events” in
order to generate returns.

Question 38

Which of the following is not a common characteristic of alternative investments?
A. Large investment size
B. Limited historical return data
C. Broad manager specialization

Answer 38

Answer: C
Alternative investments are generally taken advantage of by managers with unique and
specialized knowledge and skills.

Question 39

Which of the following is not a common risk measurement tool employed by managers of illiquid
assets?
A. Sortino ratio
B. Value at risk
C. Systematic risk

Answer 39

Answer: C
Systematic risk is a measure of the risk inherent in a market and would not be appropriate for
nonmarket securities, such as illiquid assets.

Question 40

Joel Kelly, CFA, is the portfolio manager for the SureWall Direct Property Fund and is currently
reviewing several properties owned by the fund. The largest property in the fund is a three-story
security facility near Lisbon, Portugal, which is leased by a large technology company to house
data servers and records. The property is unique in that most other technology companies in
Europe own their server centers. Which of the following valuation approaches would be least
appropriate for Kelly to use in valuing this property?
A. Replacement cost
B. Comparable sales
C. Discounted cash flow

Answer 40

Answer: B
The property is unique in that it is set up for a particular purpose and there is not likely to be
too many property transactions in the region of such a property. As such, the comparable sales
approach would be inappropriate.

Question 41

The real estate index most likely to suffer from sample selection bias is a(n):
A repeat sales index.
B REIT index.
C appraisal index.

Answer 41

A is correct. Only properties that sell in each period and are included in the index and
vary over time which may not be representative of the whole market.
B is incorrect. The REIT index is based on a set of publicly traded REITs and thus does
not suffer from sample selection bias.
C is incorrect. The appraisal index is based on a set of properties that is appraised
regularly. Thus it does not suffer from sample selection bias.

Question 42

In the context of venture capital financing, seed-stage
financing most likely
supports:
A initial commercial production and sales.
B product development and/or marketing efforts.
C transformation of an idea into a business plan.

Answer 42

B is correct. Support of product development and/or marketing efforts takes place during
seed-stage
financing.
A is incorrect. Support of initial commercial production and sales takes place during
early stage financing.
C is incorrect. Support in the transformation of an idea into a business plan takes
place during angel investing.

Question 43

Relative to traditional investments, alternative investments are best characterized
as having:
A higher correlations with other asset classes.
B unique legal and tax considerations.
C greater liquidity.

Answer 43

B is correct. Alternative investments are more likely characterized as having unique legal
and tax considerations because of the broad range and complexity of the investments.
A is incorrect because alternative investments typically have lower correlations with
traditional investments, such as stocks, bonds, and cash.
C is incorrect because alternative investments typically have underlying investments
that are illiquid.

Question 44

For a hedge fund investor, a benefit of investing in a fund of funds is least likely
the:
A higher level of due diligence expertise.
B multilayered fee structure.
C ability to negotiate better redemption terms.

Answer 44

B is correct. Funds of funds have a multilayered fee structure that will reduce the returns
to the investor.
A is incorrect because one advantage of fund of funds is that they usually have a high
level of due diligence expertise.
C is incorrect because another advantage of fund of funds is their ability to negotiate
better redemption terms such as shorter lockup and notice periods.

Question 45

If the level of broad inflation indexes is largely determined by commodity
prices, the average real yield on direct commodity investments is most likely:
A less than zero.
B equal to zero.
C greater than zero.

Answer 45

B is correct. As the price increases of commodities are mirrored in higher price indexes,
the nominal return is equal to inflation and thus the real return is zero.
A is incorrect. A negative real return implies inflation greater than nominal return.
This is not the case if commodity price increases determine inflation.
C is incorrect. A positive real return implies inflation less than nominal return. This is
not the case if commodity price increases determine inflation.

Question 46

An investor seeking an indirect debt investment in real estate will:
A purchase a mortgage-backed
security.
B purchase a commercial property.
C originate a residential mortgage

Answer 46

A is correct. Mortgage-backed
securities are pools of loans that are securitized and
offered to the financial markets providing indirect debt investment opportunities in
residential property.
C is incorrect because originators (generally financial institutions) of residential mortgages
are making a direct debt investment in the home.
B is incorrect because commercial property is considered an appropriate direct investment—
equity (i.e., ownership) and debt (i.e. lender)—for institutional or high-net-
worth
investors with long time horizons and limited liquidity needs.

Question 47

A hedge fund with $98 million of initial capital charges a management fee of
2% and an incentive fee of 20%. The management fee is based on assets under
management at year end and the incentive fee is calculated independently from
the management fee. The fee structure has a high-water
mark provision. The
fund value is $112 million at the end of Year 1, $100 million at the end of Year,
and $116 million at the end of Year 3. The net-of-
fees
return earned by the fund
in Year 3 is closest to:
A 14.15%.
B 12.33%.
C 11.87%.

Answer 47

A is correct. The net-of-
fees
return to the fund in Year 3 is closest to 14.15%, calculated
as follows:
Year 1:
Portfolio gain = Year-end
value – Beginning value = $112 million
− $98 million = $14 million
Management fee = Year-end
value × Management fee % =
$112 million × 2% = $2.24 million
Incentive fee = Portfolio gain × Incentive fee % = $14 million ×
20% = $2.8 million
Total fees = Management fee + Incentive fee = $2.24 million
+ $2.8 million = $5.04 million
Ending Capital Position = Year-end
value – Total fees
= $112 million − $5.04 million = $106.96 million
High water mark = Ending capital position = $106.96 million

Year 2:
No incentive fee is earned as the fund declines in value; the high water mark established
in Year 1 is not exceeded.
Management fee = Year-end
value × Management fee % =
$100 million × 2% = $2 million
Ending Capital Position = Year-end
value – Management fee
= $100 million − $2 million = $98 million
High water mark = Highest ending capital position =
$106.96 million

Year 3:
Net-of-
fee
returns are affected by the Year 1 high water mark and the Year 2 net capital
position (i.e. Year 3 beginning capital position).
Management fee = Year-end
value × Management fee % = $116 million
× 2% = $2.32 million
Incentive fee = (Year-end
value – High water mark) × Incentive fee
%
= ($116 million – $106.96 million) × 20% =
$1.81 million.
Total fees = Management fee + Incentive fee = $2.32 million +
$1.81 million = $4.13 million
Net-of-
fees
return = (Year-end
value – Total fees – Beginning capital
position)/Beginning capital position
= ($116 million – $4.13 million – $98 million)/$
98 million = 14.15%.

Question 48

If an investor uses derivatives to make a long investment in commodities, the
return earned on margin is best described as:
A convenience yield.
B collateral yield.
C price return.

Answer 48

B is correct. Collateral yield is the return on cash used as margin on derivatives used to
gain commodity exposure.
A is incorrect because the convenience yield (also known as “roll yield”) is the return
from rolling forward the maturity of the derivatives position.
C is incorrect because price return is the difference between the forward and spot price.

Question 49

Do management fees most likely get paid to the manager of a hedge fund,
regardless of the fund’s performance?
A No, only when the fund’s net asset value exceeds the previous high-water
mark
B No, only when the fund’s gross return is positive
C Yes

Answer 49

C is correct. Regardless of performance, the management fee is always paid to the fund
manager.
B is incorrect because the gross return can be at any level and the manager is still
paid the management fee.
A is incorrect because the management fee is paid regardless of the value of the
assets in the fund.

Question 50

Concentrated portfolio strategies are attractive because of their:
A potential to generate alpha.
B ability to track market indices.
C low risk.

Answer 50

A is correct. Concentrated portfolio strategies focus on only a few securities, strategies, or
managers. This focus reduces diversification but may enable investors to achieve alpha.
B is incorrect. Portfolio concentration makes it harder to track market indexes.
C is incorrect. Portfolio concentration increases risk.

Question 51

A commodity market is in contango when futures prices are:
A lower than the spot price.
B the same as the spot price.
C higher than the spot price.

Answer 51

C is correct. When a commodity market is in contango, futures prices are higher than
the spot price.
A is incorrect. This is the definition of backwardation.
B is incorrect. This is neither contango nor backwardation.

Question 52

Which of the following is least likely to reduce the likelihood of being defrauded
by a dishonest money manager?
A Third-party
custody of assets under management
B Strong and consistent reported investment performance
C Independent verification of investment results

Answer 52

B is correct. To prevent fraud, involvement of third parties in the reporting and asset
management process is helpful. A strong and consistent reported investment performance
that lacks outside verification may actually be a warning sign.
A is incorrect. Third-party
custody of assets under management helps to reduce the possibility of fraud.
C is incorrect. Independent verification of investment results helps to reduce the
possibility of fraud.

Question 53

A private equity firm sells a portfolio company to a buyer that is active in the
same industry as the portfolio company. This transaction is best described as
a(n):
A trade sale.
B secondary sale.
C initial public offering.

Answer 53

A is correct. A trade sale is the sale of a portfolio company to a strategic buyer, such as
a company that is active in the same industry.
B is incorrect. A secondary sale is a sale to another private equity firm.
C is incorrect. An initial public offering involves the sale of shares to public investors.

Question 54

The market approach to valuing portfolio companies in private equity firms is
most likely based on:
A present value.
B the value of assets minus the value of liabilities.
C multiples.

Answer 54

C is correct. The market approach to valuing portfolio companies uses multiples of
different measures that are compared with similar companies.
A is incorrect. Present value is calculated in the context of discounted cash flow models.
B is incorrect. The value of assets minus the value of liabilities is calculated in the
context of asset-based
models.