Chapter 20 Alternative Investments: Benefits, Risks, and Structure RQ Flashcards
What does a hedge fund’s lockup period refer to?
A. When new investors can purchase units in the fund.
B. When the fund’s short positions are expected to be covered.
C. When the fund is required to hold more than 50% of its assets in cash.
D. When the initial investment cannot be redeemed by investors.
D. When the initial investment cannot be redeemed by investors.
A lockup refers to the time period that initial investments cannot be redeemed from a hedge fund.
Which of the following offering documents is offered by a hedge fund?
A. Annual information form.
B. Offering memorandum.
C. Fund Facts.
D. Simplified prospectus.
B. Offering memorandum.
While mutual funds issue a simplified prospectus, annual information form and Fund Facts document, hedge funds usually issue an offering memorandum, which is a legal document stating the objectives, risks and terms of investment involved with a private placement.
Which of the following represents a key benefit of investing in hedge funds?
A. The funds make use of complex investment strategies.
B. Fund managers seek to achieve absolute returns.
C. The funds are lightly regulated.
D. Fund managers use strategies that always hedge against market volatility.
B. Fund managers seek to achieve absolute returns.
There are many reasons for investing in a hedge fund. Compared with mutual fund managers who seek to beat a market index, hedge fund managers seek to achieve positive or absolute returns regardless of the market’s direction.
The TKO Hedge Fund had $400 million in assets at the beginning of Year 1. The fund manager was entitled to an annual incentive fee of 15% of the fund’s return, subject to a high-water mark of $400 million. Assuming no contributions or withdrawals to or from the fund in Years 1 and 2, what incentive fees will the managers collect at the end of Year 2 if the fund returns -10% in Year 1 and 20% in Year 2? Ignore the effect of management fees and expenses.
A. $4.8 million.
B. $6.0 million.
C. $12.0 million.
D. $32.0 million.
A. $4.8 million.
An incentive fee is in addition to the management and administration fees and is based on fund performance. The incentive fee is $4,800,000.
Step 1: the value of the fund at the end of year one is $360 million ($400 - ($400 × 10%)).
Step 2: the value of the fund at the end of year 2 is $432 million ($360 + ($360 × 20)).
Step 3: the dollar amount of the increase in the fund is $32 million ($432 - $400), where the $400 is the high-water mark.
Step 4: the incentive fee is $4.8 million ($32 × 15%).
What is the set of optimal portfolios that maximizes the expected return at each risk level for an investor?
A. Symmetric allocation.
B. Skewness.
C. Kurtosis.
D. Efficient frontier.
D. Efficient frontier.
The curve that reflects the most efficient portfolios for all levels of risk is called the efficient frontier. All points below the efficient frontier are inefficient.
If hedge funds have an expected return and risk that are generally consistent with their historical return and risk, what impact will hedge funds have if they are added to a portfolio of traditional investments?
A. They will increase the portfolio’s expected return and risk equally.
B. They will increase the portfolio’s expected return more than increasing its risk.
C. They will change neither the portfolio’s expected return nor its risk.
D. They will not change the portfolio’s expected return but it will increase its risk.
B. They will increase the portfolio’s expected return more than increasing its risk.
The combination of a hedge fund with an expected return and risk consistent with the portfolio of traditional investments with similar risk and return will increase the portfolio’s expected return more than an increase in risk.
What is the key lesson of modern portfolio theory?
A. That investors can maximize expected return for a given level of risk in their portfolio through diversification.
B. That investors can reduce the downside risk of their portfolios by borrowing at the risk-free rate.
C. That investors can reap arbitrage profits by buying securities that have an expected return greater than that implied by their beta.
D. That investors should use passive investments for beta exposure and active investments such as hedge funds for alpha exposure.
A. That investors can maximize expected return for a given level of risk in their portfolio through diversification.
By combining various asset classes such as cash, bonds, equities, and non-correlated alternative investments, an investor can construct an efficient portfolio that maximizes the expected return for each level of risk in a combined portfolio.
The following table shows the 3-year correlation of four hedge funds with a portfolio weighted 60% in stocks and 40% in bonds:
Fund Correclation Omega Fund 0 Kappa Fund +0.10 Theta Fund +0.50 Lambda Fund +0.95 Which fund will offer the greatest diversification benefit when added to a portfolio weighted 60% in stocks and 40% in bonds?
A. Omega Fund.
B. Kappa Fund.
C. Theta Fund.
D. Lamda Fund.
A. Omega Fund.
Adding the fund which has the lowest correlation to the portfolio, Omega Fund, would reduce the risk and potentially increase the return of the combined portfolio, because of the beneficial interaction of two assets with a correlation of less than +1.
As a percentage of NAV, what is the permitted total short sales maximum for a conventional mutual fund?
A. 10%.
B. 15%.
C. 20%.
D. 25%.
C. 20%.
For a conventional mutual fund, the permitted total short selling limit is a maximum of 20% of the fund NAV.
Samir is a Canadian retail investor who makes $45,000 a year. Can he invest in an alternative mutual fund by a mutual fund company?
A. Yes, he can invest.
B. He cannot invest under any circumstances.
C. Yes, but he can only invest if he has a spouse whose income is at least $55,000 a year.
D. Yes, but he can only invest if he has a liquid net worth of $500,000.
A. Yes, he can invest.
The general public can invest in alternative mutual funds.
Which of the following is one of the main ways that hedge funds differ from conventional mutual funds?
A. Hedge funds can take large short positions.
B. Hedge funds are typically more diversified than mutual funds.
C. Hedge funds are available for sale only to institutional investors.
D. Hedge funds generally use derivatives only to reduce the risk of holding a security.
A. Hedge funds can take large short positions.
Hedge funds are permitted to take large short positions. They are typically less diversified than mutual funds, and permit investors who are exempt, accredited, institutional, or have a minimum initial $150,000 investment; hedge fund restrictions on the use of derivatives, if any, are set by the offering memorandum.
Private equity includes which of the following investments?
A. Infrastructure.
B. Collectibles.
C. Venture Capital.
D. Alternative mutual funds.
C. Venture Capital.
Private equity includes leveraged buyouts, growth capital turnaround investments, venture capital, mezzanine financing, and the purchase of distressed securities.
Deal breakage risk refers to what kind second-order risk?
A. The risk that the issuer of a debt security will not meet its payment obligations.
B. The risk of loss from the failure of two companies to complete an announced merger.
C. The risk of loss on a position financed with borrowed money.
D. The risk that the counterparty to an OTC agreement will not fulfill its obligations.
B. The risk of loss from the failure of two companies to complete an announced merger.
Deal breakage results when two companies break off a deal and fail to complete an announced merger.
What type of restriction does a hedge fund manager face if incentive fees are paid only on net new profits?
A. Hurdle rate.
B. Lockup.
C. High-water mark.
D. Investor protection.
C. High-water mark.
A high-water mark sets a bar, based on the fund’s previous high value, above with the manager earns incentive fees.
What is one disadvantage of investing in a fund of hedge funds?
A. Access to hedge funds.
B. Additional sources of leverage.
C. Business risk control.
D. Reduced volatility.
B. Additional sources of leverage.
Disadvantages include additional costs, no guarantees, low or no strategy diversification, insufficient or excessive diversification, and additional leverage.
