kim226

With respect to commodities and managed futures, which have investable indices?

A) Both commodities and managed futures.

B) Neither commodities nor managed futures.

C) Commodities but not managed futures.

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Indices for both asset classes use trading rules and assets to which investors have access.

kim226

Real estate has the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index as its principal benchmark. Which of the following is most accurate?

A) The volatility of the index has a downward bias.

B) The volatility of the index has an upward bias.

C) The average return of the index has an upward bias.

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Since the prices are obtained periodically, the volatility of the index has a downward bias.

kim226

With respect to hedge fund indices, back-fill bias refers to:

A) a hedge fund manager filling in historical values of his/her hedge fund’s performance when the fund has been selected to be included in an index.

B) the increased inflow of investments to a given fund in an index right after the style of the index has performed well.

C) modifying the historical series of the index by replacing the historical returns of recently dropped funds with the historical returns of new funds added to the index.

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Biases often exist in hedge fund indices because of the self-reporting of fund returns. This can apply to returns as they are earned or when filling in gaps in the historical data. The inclination is to over report. Backfill or inclusion bias is the name of the potential bias when a hedge fund joins an index and the manager adds historical data to complete the series.

kim226

With respect to hedge fund indices, survivorship bias:

A) can be as high as 1.5% to 3% and is probably low for event-driven strategies and higher for hedged-equity strategies.

B) can be as high as 1.5% to 3% and is probably high for event-driven strategies and lower for hedged-equity strategies.

C) can be as high as 3% to 5% and is probably high for event-driven strategies and lower for hedged-equity strategies.

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Survivorship bias is a big problem for these indices. Indices may drop funds with poor track records or that fail, and this will overestimate returns in the overall market. Studies have shown that the bias can be as high as 1.5% to 3% per year. The degree of survivorship bias varies among the hedge-fund strategies. It is probably low for event-driven strategies and higher for hedged-equity strategies.

kim226

One problem in creating a private equity index is the:

A) issue of leverage and how to deal with it.

B) infrequent repricing of the components.

C) problems with defining what constitutes a private equity investment.

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The value of a private equity index depends upon price-revealing events like IPOs, mergers, the raising of new financing, etc... Thus, the re-pricing of the index occurs infrequently.

kim226

For use in evaluating hedge funds, which of the following is NOT a shortcoming of the Sharpe ratio?

A) It uses an arbitrary reference return.

B) It is a stand-alone measure that ignores the diversification contributions of a hedge fund to an overall portfolio.

C) It has had little success in predicting winners.

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The Sharpe ratio is a very standardized measure, and none of the inputs are arbitrary. Both remaining choices are recognized shortcomings of the Sharpe ratio.

kim226

Suzanne Harlan has a large, well-diversified stock and bond portfolio. She wants to try some alternative investments, and has contracted with Laurence Philips, principal of Philips Finance, to help assemble a new portfolio.
Before agreeing to make recommendations for Harlan, Philips wants to determine whether she is a good candidate for alternative investments. He gives her a standard questionnaire that asks open-ended questions of all potential clients. Here are some of Harlan's comments:

• "I'm interested in high returns. I'm not afraid of risk, and I'm investing this money for the benefit of my eventual heirs."
• "I pay several million dollars in taxes every year, and I want any additional investments to be tax-friendly."
• "While I expect risk on an individual-investment basis, I'd like to further diversify my portfolio and reduce overall risk."
• "I pay a lot of attention to expense and return data from my investments and track their performance closely."
• "I'm 65 years old and in excellent health."

After reading Harlan's responses and learning that she is a fairly sophisticated investor, Philips agrees to take her on as a client. Harlan has a lot of experience with investments and has some ideas what she'd like to do. She brings Philips the following ideas:

• “I have a colleague in the lumber business who says the furniture market is booming, and demand should increase in the year ahead. I'd like to purchase some lumber futures in the hopes that the price will rise.”
• “Hedge funds are earning excellent returns, and I expect them to continue doing so. However, other investors have told me that the difficulty lies in assessing the quality of the funds, because they are not well regulated. So I'm interested in purchasing a fund of funds, so I can diversify my risk while potentially sharing in some outsized returns.”
• “I already own a couple of REITs, but they represent a very small portion of my assets, and I'd like to increase my exposure to real estate. I've heard about pooled real estate funds, and I'm interested in one of those funds.”
• “My neighbors founded Kelly Tool and Die, a machine-tool business, 20 years ago and have not managed the company well. They have told me they are considering filing for bankruptcy. I have contacts in the manufacturing business overseas who would be interested in acquiring Kelly's assets. My Asian colleagues are willing to pay about 60% of book value for the assets, and my neighbors are willing to sell me the company for about 50% of the book value of its assets.”

Harlan then tells Philips that it is imperative that the returns of any investments he recommends must be in some way comparable to a benchmark.
Philips is not excited about the commodity idea and does not like funds of funds. However, he does know of several managers of individual hedge funds that might interest Harlan. He talks her out of the fund of funds idea and suggests she put her money in the Stillman Fund, which is run by one of his college friends. Fund manager Mark Stillman concentrates on spin-offs, generally buying the spun-off company and shorting the parent company.
Harlan seeks alternative investments that will both boost returns and diversify her portfolio. Which pair of her proposed investments represents the worst choices for each goal?

Net returns

Diversification

A) Lumber Kelly Tool and Die

B) Lumber Hedge funds

C) Real estate funds Hedge funds

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Commodity investments are primarily diversification tools, having little correlation with traditional stocks and bonds. The Kelly Tool and Die investment is private equity, which is more of a return enhancer than a diversifier. Real estate funds can boost both diversification and returns, while hedge funds can boost returns, diversify, or both, depending on the nature of the fund. (Study Session 13, LOS 31.f)

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Based on her investment suggestions and survey answers, Harlan is least concerned with:

A) inflation.

B) volatility.

C) liquidity.

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While Harlan's comment about being willing to accept risk may suggest she is not concerned about volatility, she is most definitely concerned on a portfolio level, as evidenced by her desire to use alternative assets for diversification purposes. Nothing in the information presented above offers any hint about Harlan's concerns about inflation. However, Harlan's stated desire to build wealth for her heirs suggests liquidity is not a concern. (Study Session 13, LOS 31.f)

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In his attempt to talk Harlan out of investing in a fund of funds, Philips addressed the advantages of investing in individual funds. Which of the following is his most compelling argument?

A) The likelihood of style drift in a fund of funds.

B) The lack of benchmarks for a fund of funds.

C) The lower expenses of individual funds.

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The biggest disadvantage of the fund of funds is the extra layer of fees. Style drift could be an issue for both an individual hedge fund and a fund of funds, much as it is with traditional mutual funds. The issue with benchmarks is probably more troubling for individual funds than for funds of funds. (Study Session 13, LOS 31.r)

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The Stillman fund uses which strategy?

A) Relative value.

B) Hedged equity.

C) Merger arbitrage.

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Merger arbitrage funds usually focus on mergers, spin-offs, or takeovers, buying one company in the transaction and shorting the other. (Study Session 13, LOS 31.p)

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Which of Harlan's responses is most likely to make Philips consider her a bad candidate for alternative investments?

A) "I pay several million dollars in taxes every year, and I want any additional investments to be tax-friendly."

B) "I'm interested in high returns. I'm not afraid of risk, and I'm investing this money for the benefit of my eventual heirs."

C) "I pay a lot of attention to expense and return data from my investments and track their performance closely."

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Many alternative assets provide high returns, and a high risk tolerance and low need for liquidity are positives for investors in alternative asset classes. And while many alternative assets are risky, they can provide a substantial diversification benefit when combined with mainstream investments. Many alternative investments are tax-friendly. However, most of the investments considered for this exam are not easy to value, and difficult to track closely over short periods of time. (Study Session 13, LOS 31.a)

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If Harlan is truly concerned about benchmarks, she should avoid which of her suggested investments?

A) Kelly Tool and Die.

B) Hedge funds.

C) None of them, benchmarks are available for all asset classes.

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Benchmarks are available for commodities, real estate, private equity, and hedge funds, though not all of them are easy to interpret. (Study Session 13, LOS 31.e)

kim226

When added to a portfolio of stocks and bonds, based upon historical performance, we can expect distressed securities to contribute:

A) enhanced return but not diversification.

B) both enhanced return and diversification.

C) diversification but not enhanced return.

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They can provide high returns because many investors cannot hold distressed debt securities, and few analysts cover the market. Based on comparisons of the average and Sharpe ratio, the HFR Distressed Securities Index outperformed both stocks and bonds both absolutely and on a risk-adjusted basis. The returns are often event-driven so the return is uncorrelated to the overall stock market and can provide diversification.

kim226

As an asset class, over the period 1990-2004, commodities would:

A) have enhanced the return of a stock and bond portfolio largely from the performance of the energy subgroup.

B) not have enhanced the return of a stock and bond portfolio and would have done worse except for the performance of the energy subgroup.

C) not have enhanced the return of a stock and bond portfolio largely from the underperformance of the energy subgroup.

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The returns on commodities have generally been lower over the longer period of 1990-2004 than stocks and bonds both absolutely and on a risk-adjusted basis. The energy subgroup of commodities has had the highest returns, and without it, the broad GSCI index return would have been much lower.

kim226

When compared to a portfolio of publicly traded stocks, private equity is:

A) correlated with stocks but adds moderate diversification because of its idiosyncratic risk component.

B) uncorrelated with stocks and adds a high degree of diversification.

C) correlated with stocks and has a low idiosyncratic risk component so it adds virtually no diversification.

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Private equity returns typically move with stock market returns. Computed correlations are often positive and low, but some attribute the low correlation to the infrequently-updated or “stale” prices of the private equity returns. Each investment has a large idiosyncratic risk component, however, which can provide moderate diversification.