CFA

CHAPTER 47

INTRODUCTION TO
ALTERNATIVE INVESTMENTS

1. (A) smoothing.
Explanation
Appraisal methods used to value real estate tend to produce smoothed return
patterns that understate standard deviations of returns. This causes measures of
risk-adjusted returns, such as the Sharpe ratio, to be biased upward. Methods
used to construct real estate indexes tend to understate the correlation of real
estate returns with other asset classes (and thus overstate its diversification
benefits).
(Study Session 16, Module 47.4, LOS 47.g)
Related Material
SchweserNotes - Book 4

2. (B) a request for redemption of shares, within which the fund must fulfill the request.
Explanation
The notice period is the time within which a hedge fund must fulfill a request for
redemption of shares. The period during which investors may not redeem shares is
called a lockup period. (Study Session 16, Module 47.2, LOS 47.d)
Related Material
SchweserNotes - Book 4

3. (A) Unique legal structures and tax treatments.

Explanation
Compared to traditional investments, alternative investments have unique legal
issues and tax treatments that are related to their legal structure and registrations.
They often have lower levels of regulation and are less transparent than traditional
asset classes. Alternative investments often employ high levels of leverage in
illiquid markets.
(Study Session 16, Module 47.1, LOS 47.a)
Related Material
SchweserNotes - Book 4

Alternative Investments 1 Introduction to Alternative Investments

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4. (C) clawback.
Explanation
A clawback provision requires the manager to return any periodic incentive fees to
investors that would result in investors receiving less than 80% of the profits
generated by portfolio investments as a whole.
(Study Session 16, Module 47.3, LOS 47.e)
Related Material
SchweserNotes - Book 4

5. (A) short position in acquirer, long position in firm being acquired.

Explanation
Merger arbitrage funds typically short the stock of the acquirer and buy the stock
of the firm being acquired.
(Study Session 16, Module 47.2, LOS 47.d)
Related Material
SchweserNotes - Book 4

6. (A) the commodity has a high convenience yield.

Explanation
Backwardation refers to a situation where the futures price is less than the spot
price for a commodity. Because commodities have no monetary yield, only a
convenience yield greater than the opportunity (interest) cost and storage costs of
holding the commodity can lead to backwardation. When a futures market is in
backwardation, the roll yield is positive because the futures price moves towards
the spot price over the life of the contract.
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7. (B) leveraged.
Explanation
Alternative investments tend to use more leverage and are typically less liquid and
less transparent than traditional investments.
(Study Session 16, Module 47.1, LOS 47.a)
Related Material
SchweserNotes - Book 4

8. (A) mezzanine-stage financing.

Explanation
Mezzanine stage capital prepares a company for and IPO. Angel investing and
early-stage financing describe venture capital in a company's formative stages.
(Study Session 16, Module 47.3, LOS 47.e)
Related Material
SchweserNotes - Book 4
Alternative Investments 2 Introduction to Alternative Investments
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9. (A) the portfolio company to one of the portfolio company's competitors.
Explanation
A trade sale involves selling a portfolio company to a competitor or another
strategic buyer. An IPO involves selling all or some shares of a portfolio company
to the public. A secondary sale involves selling a portfolio company to another
private equity firm or a group of investors.
Related Material
SchweserNotes - Book 4

10. (C) correlations of fund returns with equity returns to be biased downward.
Explanation
Infrequent valuation results in downward bias in both standard deviations and
correlations.
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SchweserNotes - Book 4

11. (B) Early stage.

Explanation
The description relates best to the early stage wherein the capital that is supplied
helps speed up product development and also helps pay for the beginning of a
marketing campaign.
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SchweserNotes - Book 4

12. (B) an event driven strategy.

Explanation
Event-driven strategies include merger arbitrage, distressed/restructuring, and
special situations strategies that involve long or short positions in common equity,
preferred equity, or debt of a specific corporation. Macro strategies are based on
global economic trends and events, and may involve long or short positions in
equities, fixed income, currencies, or commodities. Equity hedge strategies seek to
profit from long and short positions in publicly traded equities and derivatives
with equities as their underlying assets, but are not based on events such as
restructuring or acquisition.
(Study Session 16, Module 47.2, LOS 47.d)
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SchweserNotes - Book 4

Alternative Investments 3 Introduction to Alternative Investments

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13. (A) a firm's historical returns are included when it is added to an index.
Explanation
Backfill bias refers to bias introduced by including the previous performance data
for firms added to a benchmark index.
(Study Session 16, Module 47.5, LOS 47.i)
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SchweserNotes - Book 4

14. (A) in contango.

Explanation
Futures price Spot price (1 + risk-free rate) + storage costs - convenience yield. If
the convenience yield is close to zero, it is likely that the futures price exceeds the
spot price, i.e., the market for the commodity is in contango.
(Study Session 16, Module 47.4, LOS 47.f)
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SchweserNotes - Book 4

15. (A) management fees.

Explanation
Hedge fund fee structures indicate management fees as a percentage of assets
under management and incentive fees as a percentage of gains in value. A 3-and-
15 fee structure means a fund charges a 3% management fee and a 15%
incentive fee.
(Study Session 16, Module 47.1, LOS 47.c)
Related Material
SchweserNotes - Book 4

16. (B) appraisal index.

Explanation
Appraisal index returns are based on estimates of property values. Because
estimating values tends to introduce smoothing into returns data, appraisal index
returns are likely to have lower standard deviations than index returns based on
repeat sales or trading prices of REIT shares.
(Study Session 16, Module 47.4, LOS 47.g)
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SchweserNotes - Book 4

Alternative Investments 4 Introduction to Alternative Investments

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17. (A) can serve as a hedge against inflation.
Explanation
Commodities can serve as a hedge against inflation because commodity prices
tend to move with inflation rates. A traditional investment portfolio may gain a
diversification benefit from an allocation to commodities because they do not have
a strong positive correlation with stock and bond prices. While it is possible for
commodity futures markets to change between backwardation and contango, this
does not necessarily benefit a commodities investor.
(Study Session 16, Module 47.4, LOS 47.f)
Related Material
SchweserNotes - Book 4

18. (B) notice period.

Explanation
A notice period, typically 30 to 90 days, is the amount of time a fund has after
receiving notice of a redemption request to fulfill the redemption request. A
lockup period is a minimum length of time before an investor may redeem shares
or make withdrawals.
(Study Session 16, Module 47.2, LOS 47.d)
Related Material
SchweserNotes - Book 4

19. (B) time-period bias.

Explanation
Index returns for alternative investments are often subject to both backfill and
survivorship bias. Time-period bias is a concern in hypothesis testing.
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20. (B) seed stage.

Explanation
In the seed stage of venture capital investing, capital is furnished for product
development, marketing, and market research. The angel investing stage is when
investment funds are used for business plans and assessing market potential. The
early stage refers to investments made to fund initial commercial production and
sales.
(Study Session 16, Module 47.3, LOS 47.e)
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SchweserNotes - Book 4

Alternative Investments 5 Introduction to Alternative Investments

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21. (A) less than 20% of the increase in value in Year 3 after management fees.
Explanation
Because the fund lost value in Year 2 and has a high water mark, incentive fees for
Year 3 will be 20% of only the portion of the Year 3 gain that exceeds the
previous highest value.
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SchweserNotes - Book 4

22. (B) greenfield infrastructure investments.

Explanation
Greenfield investments are infrastructure assets to be built. Brownfield investments
are infrastructure assets that already exist.
(Study Session 16, Module 47.4, LOS 47.h)
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SchweserNotes - Book 4

23. (B) decrease portfolio variance only.

Explanation
Unlike most alternative investments, expected returns on commodities are typically
less than expected returns on traditional investments. However, because their
returns typically have a low correlation with returns on traditional investments,
adding commodities to a portfolio of traditional investments can decrease
portfolio variance.
(Study Session 16, Module 47.4, LOS 47.f)
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SchweserNotes - Book 4

24. (A) Sortino ratio.

Explanation
The Sortino ratio uses downside deviation as its risk measure. The Sharpe ratio
uses standard deviation and the Treynor ratio uses beta.
(Study Session 16, Module 47.5, LOS 47.i)
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SchweserNotes - Book 4

25. (A) growing revenues and earnings rapidly.

Explanation
Fundamental growth refers to investing in companies that are experiencing high
growth and for which the fund managers anticipate significant capital appreciation.
Related Material
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Alternative Investments 6 Introduction to Alternative Investments

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26. (A) seed stage.
Explanation
Seed stage financing is used for market research and to fund product
development and/or marketing and is typically the first stage at which a venture
capital fund will invest in a start-up company.
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SchweserNotes - Book 4

27. (C) higher fees.

Explanation
A hedge fund typically is more likely to use leverage, is less liquid, and charges
higher fees than a traditional mutual fund.
(Study Session 16, Module 47.1, LOS 47.a)
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SchweserNotes - Book 4

28. (C) convertible arbitrage.

Explanation
Relative value strategies include convertible arbitrage fixed income, asset-backed
fixed income, general fixed income, volatility, and multi-strategy. Market neutral is
an equity hedge strategy. Merger arbitrage is an event driven strategy.
(Study Session 16, Module 47.2, LOS 47.d)
Related Material
SchweserNotes - Book 4

29. (B) to prepare for an initial public offering.

Explanation
Mezzanine-stage venture capital financing provides capital during the period prior
to an initial public offering.
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30. (A) stratified sampling.

Explanation
Stratified sampling divides the population according to common characteristics
and then selects samples from each subgroup in proportion to the subgroup's
representation in the overall population.
(Study Session 16, Module 47.2, LOS 47.d)
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SchweserNotes - Book 4

Alternative Investments 7 Introduction to Alternative Investments

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31. (C) health care facilities.
Explanation
Health care facilities are categorized as social infrastructure. Waste treatment
plants are utility infrastructure. Broadcasting towers are communications
infrastructure.
(Study Session 16, Module 47.4, LOS 47.h)
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SchweserNotes - Book 4

32. (A) liquidity risk.

Explanation
Direct investment in real estate involves liquidity risk because large sums may be
invested for long periods before a sale of the property can take place. Market risk
exists for both traditional portfolio and real estate investments. Counterparty risk
applies mainly to derivative contracts that require a payment from a counterparty,
such as swaps and forwards.
(Study Session 16, Module 47.4, LOS 47.g)
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SchweserNotes - Book 4

33. (C) management fee.

Explanation
"2-and-20" denotes a 2% management fee and a 20% incentive fee. (Study
Session 16, Module 47.1, LOS 47.c)
Related Material
SchweserNotes - Book 4

34. (C) both increase expected returns and decrease portfolio variance.
Explanation
For a portfolio of traditional securities, adding alternative investments such as
hedge funds can potentially increase the portfolio's expected returns, because
these investments often have higher expected returns than traditional investments,
and decrease portfolio variance, because returns on these investments are less
than perfectly correlated with returns on traditional investments.
(Study Session 16, Module 47.2, LOS 47.d)
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SchweserNotes - Book 4

Alternative Investments 8 Introduction to Alternative Investments

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35. (C) short bias strategy.
Explanation
Equity hedge funds with a short bias attempt to profit from short positions in
equities they believe to be overvalued. These funds may hold long equity positions
but typically have net short exposure to the market. An event driven strategy
focuses on companies involved in mergers, in financial distress, or in other special
situations. A fundamental value strategy attempts to identify undervalued equities.
(Study Session 16, Module 47.2, LOS 47.d)
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SchweserNotes - Book 4

36. (B) soft hurdle rate.

Explanation
With a soft hurdle rate, a hedge fund charges an incentive fee on all profits, but
only if the fund's rate of return exceeds a stated benchmark. With a hard hurdle
rate, a hedge fund charges an incentive fee only on the portion of returns that
exceed a stated benchmark. With a high water mark, a fund's value must exceed its
highest previous value before the fund may charge an incentive fee.
(Study Session 16, Module 47.2, LOS 47.d)
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SchweserNotes - Book 4

37. (A) private investment in public equity.

Explanation
Private investment in public equities refers to a private equity firm providing
equity financing to publicly traded companies. Angel investing refers to financing
the formation of a business. Mezzanine-stage financing refers to capital provided
to a firm as it prepares for an intial public offering.
Related Material
SchweserNotes - Book 4

Alternative Investments 9 Introduction to Alternative Investments