Questions - Part 3

Question 1

Benefits of replication products

Answer 1

The most important benefit from investing in replication products is the enhancement of absolute and risk-adjusted portfolio returns.

This benefit can arise from earning alpha or by investing in alternative beta exposures that are underweighted or not held in traditional portfolios.

Liquidity risk is another source of return not available in traditional investments.

Finally, a time-varying traditional source of beta (e.g., a dynamic beta that results from actively managing a portfolio) could be considered an alternative source of beta.

Question 2

Three major advantages of investing directly with hedge funds

Answer 2

(1) the cost savings from avoiding an extra layer of fees charged by a fund of hedge funds,

(2) access to cost-effective, experienced consultants to assist implementing the approach, and

(3) the ability to have improved control and transparency in the asset allocation and due diligence process.

Question 3

Benefits of investing in liquid alternatives over direct hedge funds

Answer 3

Have lower fees,

Better liquidity, and

Improved transparency.

Question 4

Tradeoff investable hedge fund index providers face

Answer 4

More funds to be more representative and using fewer funds to facilitate management

Question 5

Property unit trusts (PUTs)

Answer 5

Property unit trusts (PUTs) are unlisted investment vehicles comprised of a portfolio of properties held in the name of a trust. PUTs are the most important open-end investment product used by pension funds and insurance funds to obtain exposure to the U.K. real estate market. The prices of PUTs are calculated using appraisals.

Question 6

Three main criticisms for non-traded REITs

Answer 6

Illiquidity of non-traded REITs may give the false impression of low return volatility.

High fees and frequently entail significant conflicts of interests.

Leverage is often used to finance current dividend payments. This practice sometimes conceals their inability to generate future dividends.

Question 7

Six advantages of listed real estate funds

Answer 7

1) They help diversify real estate specific risk (similar to the case of unlisted real estate funds).

2) These types of funds are liquid and divisible.

3) They provide instant exposure to a real estate portfolio.

4) They convey information to the investors.

5) Some listed real estate funds allow the targeting of subsectors or regions (similar to the case of unlisted real estate funds).

6) They provide tax benefits, such as exemption from corporate taxes (similar to the case of unlisted real estate funds).

Question 8

Return to commodity beta

Answer 8

The return to commodity beta is defined as the fundamental risk-based return from holding a passive long position in a commodity.

Question 9

Primary vehicle used by institutional investors to obtain indirect commodity exposure

Answer 9

Commodity Index Swaps

Question 10

Main drawbacks of commodity index swaps

Answer 10

Limited access: commodity index swaps are available only to large, highly credit-worthy investors

Limited exit: the secondary market for commodity index swaps is not liquid

Additional risks: swaps experience greater counterparty risk than commodity futures markets

Question 11

Principal advantage of master limited partnership (MLP) structures

Answer 11

Avoiding corporate taxation. Income from qualifying MLPs is distributed directly to investors.

Question 12

Difference between ETFs and ETNs (Commodity Based) (4x)

Answer 12

1) ETNs are zero coupon instruments

2) The return to the ETN is subject to the credit-worthiness of the issuer

3) The price of the ETN is based on a contractually designated relationship with the underlying index

4) ETNs may qualify for capital gains tax treatment if held for a sufficiently long period of time

Question 13

Seven major potential advantages of listed assets

Answer 13

1) Greater liquidity

2) Lower managerial fees

3) Easier diversification

4) Visible indications of market values

5) Regulatory oversight,

6) Greater access to financing

7) Tax simplification.

Question 14

Seven major potential advantage of privately organized assets

Answer 14

1) Illiquidity premium

2) More incentivized managers

3) Greater asset targeting by investors

4) Appearance of stable values

5) Greater investor oversight

6) Greater managerial flexibility

7) Tax benefits.

Question 15

Ways in which private equity GPs can create wealth

Answer 15

(1) assembling a top management team,

(2) selecting portfolio companies with high return potential,

(3) working with or replacing the management teams of those portfolio companies,

(4) tapping the GP’s networks to bring in personnel and contacts to optimize the potential success of each portfolio company, and

(5) assisting the successful portfolio companies to perform exits that maximize the creation of wealth.

Question 16

Two competing explanations for the divergence in performance between listed REITs and private properties

Answer 16

1) Listed REITs accurately represents the true changes in the values of real estate properties adjusted for the effects of leverage. This argument asserts that property value fluctuations are delayed due to appraisal methods, which mute true fluctuations.

2) Listed REITs and their high volatility emanate from a contagion effect of public equity markets, which does not represent the underlying economic fundamentals of real estate. Therefore, the volatility of private properties better reflect the realities of the real estate market.

Question 17

Market segmentation impact performance divergence between listed REITs and private properties

Answer 17

Many institutions may have limited need for liquidity throughout their entire portfolios and may view their investments with longer-term horizons. Invetors with shorter-term horizons and a higher need for liquidity may perceive listed REITs as providing the liquidity they desire with low transaction costs.

Question 18

Three key empirical findings regarding private equity performance

Answer 18

1) Venture capital fund performance tends to exceed that of buyout funds,

2) Private equity outperformance and performance persistence have generally been lower in more recent years (since 2000)

3) Risk-adjustment of returns and netting of fees tended to lower private equity performance to unattractive levels.

Question 19

Under what circumstance should an investor opt to invest in liquid structures relative to private structures

Answer 19

Generally, investors should invest in listed structures when managers with unremarkable skill or limited investment opportunities exist.

Question 20

Blue-chip team

Answer 20

A team that has been able to produce top-quartile performance for all of its funds through at least two business cycles (i.e., a sequence of more than three funds).

Question 21

Three fundamental screening questions regarding an investment process

Answer 21

1) What is the investment objective of the fund?

2) What is the investment process of the fund manager?

3) What is the nature and source of any value added by the fund manager?

Question 22

Three potential reasons an actual investment strategy may differ from the stated investment strategy

Answer 22

Style drift,

Operational errors,

Fraud.

Question 23

Investment process risk differ from market risk

Answer 23

Investment process risk comes from the imperfect application of the investment mandate, resulting in errors or purposeful decisions that result in exposures that do not match the investment mandate.

Market risk measures the risk of the overall market, not the risk of an investment strategy being improperly implemented.

Question 24

Four implications of conflicts of interest in fund asset valuation

Answer 24

(1) obscure or delay losses,

(2) smooth returns by shifting performance between reporting periods,

(3) vary risks to recoup losses or lock in profits, and

(4) inflate valuations to increase fees.

Question 25

Bias Ratio

Answer 25

The bias ratio attempts to indicate when returns have been manipulated and thus do not exhibit a distribution consistent with competitive markets.

Question 26

Three important questions in a risk management review

Answer 26

1) What are the types and levels of risk involved in the fund manager’s strategy?

2) What risks are measured, monitored, and managed?

3) How are risks measured, monitored, and managed?

Question 27

Functions of a chief risk officer

Answer 27

Identifying,

measuring,

monitoring, and

managing risk

Question 28

Four primary ways in which hedge funds deal with cash

Answer 28

Cash for fund expenses.

Cash to facilitate trading.

Cash flows to and from investors.

Unencumbered cash.

Question 29

Eight core elements of the operational due diligence process

Answer 29

1) Document collection

2) Document analysis

3) On-site visit

4) Service provider review and confirmation

5) Investigative due diligence

6) Process documentation

7) Operational decision

8) Ongoing monitoring (if investment made)

Question 30

Three assumptions of a Geometric Brownian Motion (GBM)

Answer 30

(1) a constant variance through time,

(2) are normally distributed,

(3) are uncorrelated through time.

Question 31

Portfolio’s vega

Answer 31

Measuring the response of the current price of a portfolio to a change in the market’s anticipated volatility of the returns of the portfolio’s underlying asset.

Question 32

Is vega profit likely to be obtainable

Answer 32

The profit is likely to be substantially lower and even close to zero. This is because as the volatility increases, the price of the underlying asset is likely to decline in price. Even though the position is delta hedged, one needs to account for changes in the vega as the price moves lower. In particular, the vega will decline substantially.

Question 33

Short Iron Condor

Answer 33

A short position in an iron condor is created when a trader sells an out-of-the-money bull spread and an out-of-the-money bear spread. A bull spread is created by going long a call option with a lower strike price and shorting a call with a higher strike price. A bear spread is created by going long a call option with a higher strike price and shorting a call option with a lower strike price. Bull and bear spreads can also be created using put options.

Question 34

Motivations behind opacity in the context of delegated portfolio management

Answer 34

Opacity can emanate from principal-agent problems and the incentive for managers to obscure sources of return variability in order to reduce the likelihood of being perceived as an unskilled manager.

Question 35

Hedging ABL Strategies

Answer 35

Borrowers tend to be small

Businesses are highly idiosyncratic.

Hedging a long portfolio constituted by small issuers with a short portfolio of larger bond issuers creates basis risk.

Question 36

Three most typical external credit enhancements from credit card receivables

Answer 36

(1) Cash collateral accounts,

(2) third-party letters of credit, and

(3) collateral invested amounts.

Question 37

Four most common internal credit enhancements from credit card receivables

Answer 37

(1) Senior/subordinated certificates,

(2) spread accounts,

(3) excess finance charges,

(4) overcollateralization

Question 38

The relationship between price stickiness and the need to currency hedge an asset

Answer 38

To the extent that assets have barriers to international trade, substantial transportation costs, high trading costs, and substantial taxation, the prices of those assets may deviate from those predicted by the law of one price for substantial periods of time. If prices are stickier, then currency hedging may be more necessary.

Question 39

Direct property ownership through partnerships with a small number of investors

Answer 39

An investor’s relationship with real estate managers may be particularly important in this case, because the real estate investor cannot rely on other investors to control and monitor the real estate manager.

Compare this situation to the case of public equity investing, where an investor can remain passive in most cases.