Review

Question 1

What does the statistical method of analysis include?

Answer 1

1. the mean of distribution, and
2. the standard deviation or variance of the distribution

non-normality is addressed through the analysis of higher moments of the return distributions, such as skewness and kurtosis.

(normally traditional investment analysis is based on the mean and standard deviation)

Question 2

What Three 3 points help form the complex differentiation between alternative and traditional investments?

Answer 2

1. Information Asymmetries: extent to which market participants possess different data and knowledge.
2. Incomplete Markets: insufficient distinct investment opportunities.
3. Innovation

Question 3

Name the four return characteristics that differentiate traditional and alternative investments.

Answer 3

1. Diversification
2. Illiquidity
3. Inefficiency
4. Non-normality

Question 4

What is Moral Hazard?

Answer 4

Risk that the behavior of one or more parties will change after entering into contract.

Question 5

What is a Benchmark?

Answer 5

A performance standard for a portfolio that reflects the preferences of an investor with regard to risk and return

Question 6

List the three major types of alternative investments other than real assets in the CAIA curriculum.

Answer 6

1. Hedge funds (managed futures, 38%)
2. Private equity (including mezzanine and distressed debt, 29%)
3. Structured products (including credit derivatives, 3%

Question 7

What are the Goals of Alternative Investing?

Answer 7

1. Active management
2. Absolute and relative returns
3. Arbitrage, Return Enhancers, and Risk Diversifiers

Question 8

What is the Absolute Return standard?

Answer 8

Returns are to be evaluated relative to zero, a fixed rate, or relative to the riskless rate, and therefore independently of performance in equity markets, debt markets, or any other markets

Question 9

What is the Relative Return standard?

Answer 9

Returns are to be evaluated relative to a benchmark.

Question 10

What is Active Management?

Answer 10

Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return.

Question 11

What are the Four Methods of Alternative Investment Analysis:

Answer 11

1. return computation methods
2. statistical methods
3. valuation methods
4. portfolio management methods

Question 12

Two common forms of structured products:

Answer 12

CDOs and Credit Derivatives

Question 13

List four major types of real assets other than land and other types of real estate.

Answer 13

1. Natural Resources
2. Commodities
3. Infrastructure
4. Intellectual property

Question 14

What is Institutional Capital?

Answer 14

Pension funds or endowments.

Question 15

What are the five primary forms of hedge fund regulation?

Answer 15

1. Requirements regarding establishing a hedge fund, including registration, licensing, minimum capital, and waiting periods.
2. Registrations or restrictions on investment advisers and hedge fund managers.
3. Restrictions on distributions and marketing of hedge funds including which marketing channels may be used (e.g. banks), whether advertising is permitted, and to whom funds may be sold.
4. Restrictions on operation of a hedge fund, including leverage, liquidity, risk reporting, and location of outside service providers.
5. Requirements regarding ongoing reporting.

Question 16

Soft dollar arrangements must be disclosed to clients in trading practices. What are soft dollar arrangements?

Answer 16

Refers to an agreement or an understanding by which an investment adviser receives research services from broker-dealer in exchange for a fee (such as a commission) paid out of the fund or client account.

Question 17

List several advantages of Separately Managed Accounts (SMAs) relative to funds.

Answer 17

• A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record.
• A fund invests for the common purposes of multiple investors, while an SMA may have
  objectives tailored to suit the specific needs of the investor, such as tax efficiency.
• A fund is often opaque to its investors to promote confidentiality; an SMA offers
  transparency to its investor.
• Fund investors may suffer adverse consequences from redemptions (withdrawals) and subscriptions (deposits) by other investors, but an SMA provides protection
  from these liquidity issues for its only investor.

Disadvantage:
- A fund structure may allow investors to have limited liability, the SMA format may allow losses to be greater than the capital contribution when leverage or derivates are used.

Question 18

Federal Reserve Board leverage rules include the Regulation T margin rule, what is this rule?

Answer 18

According to Regulation T, an investor may borrow up to 50% of the purchase price of securities that can be bought using a loan from a broker or dealer. The remaining 50% of the price must be funded with cash.

Question 19

MiFID

Answer 19

Markets in Financial Instruments Directive: is an EU law that establishes uniform regulation for investment managers in the European Economic Area (+ Iceland, Norway, and Liechtenstein).

Question 20

In terms of financial regulation, what is the FCA?

Answer 20

Financial Conduct Authority – the primary regulator of financial services in the UK.

Question 21

A dark pool is?

Answer 21

Non-exchange trading by large market participants that is hidden from the view of most market participants.

Question 22

What are the five distinct types of liquid alternative funds?

Answer 22

1. Unconstrained clones: liquid funds that follow virtually the same strategy as private placement products with underlying liquid assets, such as some hedge funds or managed futures funds.
2. Constrained clones: these liquid funds implement a similar strategy as private placement products but are limited in risk exposure by leverage, concentration, or liquidity constraints.
3. Liquidity-based replication products: these liquid funds are designed to mimic illiquid private placement investment, using liquid securities as proxies.
4. Skill-based replication products: these liquid funds are designed to mimic a highly skilled private placement strategy using a simplified and more mechanical strategy.
5. Absolute return or diversified products: these liquid funds are designed to offer absolute returns and/or diversifying returns not directly related to opportunities historically available in private placements and potentially inconsistent with alternative strategies as typically deployed.

Question 23

What are the differences between a Hedge Fund Replication and Close-End Mutual Fund?

Answer 23

Hedge fund replication: attempt to mimic the returns of an illiquid or highly sophisticated hedge fund strategy using liquid assets and simplified trading rules.

Closed-end mutual fund: provide investors with relatively liquid access to the returns of underlying assets even when the underlying assets are illiquid.

Question 24

Four factors determining performance of liquid alternative compared to private placements

Answer 24

Four factors determining performance of liquid alternative compared to private placements:

1. The permissible investment strategies differ. Private placements often enjoy important flexibility with regard to leverage (including the magnitude of short position) and concentration (lack of diversification).
2. Similarly, private placements may be able to generate higher returns due to their investment flexibility to hold more illiquid assets, thereby potentially receiving higher liquidity premiums.
3. Fees differ between liquid alternatives and private placements. Liquid alternatives tend to have lower fees because most do not have incentive fees, especially asymmetric incentive fees wherein managers benefit from sharing upside profits but are limited in their exposure to downside losses.
4. Managerial skill may differ. The higher potential fees from the asymmetric incentive fees of private placements may attract managers with greater skill. Some liquid alternative funds implement simplified trading rules rather than hiring sophisticated management teams.

Question 25

Name five private investment pools.

Answer 25

1. Hedge funds
2. Funds to funds
3. Private equity funds
4. Managed future funds
5. Commodity Trading Advisors (CTAs)

Question 26

What are MLPs?

Answer 26

Master Limited Partnerships.

These are publicly traded investment pools that are structured as limited partnerships and that offer their owners pro rata claims. MLPs are traded on major stock exchanges, but they have legal and tax structures similar to those of private limited partnerships.

Question 27

What are Large Dealer Banks?

Answer 27

Proprietary Trading and Broker Hedge Funds

Question 28

Four major legal documents necessary for establishing and managing a hedge fund.

Answer 28

1. Private-placement memoranda - formal descriptions of an investment opportunity that comply with federal securities regulations.
2. partnership agreement - contract creating a partnership.
3. subscription agreement - application submitted by an investor who desires to join a limited partnership.
4. management company operating agreement - agreement between members related to a limited liability company and the conduct of its business as it pertains to the law.

Question 29

What is the FCA?

Answer 29

The Financial Conduct Authority – the primary regulator of financial services in the UK.

Question 30

Holding their clients’ cash and securities and settling clients’ trades

Answer 30

Depository Trust Company (DTC) is the principal holding body of securities for traders all over the world and is part of the Depository Trust Company Corporation (DTCC).

Question 31

Hedge Fund Infrastructure includes:

Answer 31

1. Financial platforms - systems that provide access to financial markets, portfolio management systems, accounting and reporting systems, and risk management systems.
2. Financial software - prepackaged software programs and computer language tailored to the needs of financial organisations.
3. Financial data providers -
   supply raw financial market data, including security prices, trading information, and indices.

Platforms, Software, Data Providers

Question 32

Name four outside service providers.

Answer 32

1. Prime broker - clears and finances trades for clients, provides research, arranging financing and producing trades for its client.
2. Accountants - helps prepare partnership returns and the necessary forms for the investors in the fund to report their shares of partnership income, deductions, gains, and losses. Also audits and tax returns.
3. Attorneys - helps determine the best legal structure for a fund’s unique investment strategies, objectives, and desired investors.
4. Fund administrators - responsible for bookkeeping, third-party information gathering, and securities (onshore and offshore).

Prime, Accountants, Attorneys, Fund Admin

Question 33

Bid-ask spread:

Answer 33

The price difference between the highest bid price (the best bid price) and lowest offer (the best ask price).