Topic 6.1-6.5

Describe the tradeoff investable hedge fund index providers face.

- including more funds to be more representative and -using fewer funds to facilitate management.

Briefly describe the basic structure of a commodity index-linked note, and state two advantages of this note over a futures contract.

1pt: A commodity index-linked note is a debt instrument that, at maturity, provides the note holder principal and a return linked to the performance of a commodity or set of commodities. Advantages (compared to futures) - 1pt each Attractive to investors who prefer to hold bonds due to regulatory restrictions (since they cannot hold futures contracts) No posting of collateral required (since the notes are fully collateralized)

Define alternative beta, and give an example of an alternative beta product.

1pt: Alternative beta refers to exposure to risk or return that is not typically available with traditional assets or, if available, is bundled with other risks. 1pt: Examples (give one): common stocks exposed to volatility risk, currency investments, and structured products.

Hedge fund replication products are known to have unique benefits not available with standard hedge fund investments. Some of these benefits include lower fees, less due diligence, and greater transparency. State three other benefits offered by most hedge fund replication products that are not available with direct hedge fund investments.

Below are replication products' unique benefits. State any three (except 2, 5, and 8, which were given in the question). 0.5pts each Liquidity - replication products typically invest in liquid instruments (e.g., ETFs or futures). Transparency Flexibility (of risk profiles) Lower fees Hedging - replication products created with liquid securities can be shorted. Lower due diligence and monitoring risks Diversification - replication products that use diversified factors (e.g., ETF or futures returns) provide diversification benefits. Benchmarking

Why might it benefit a GP to engage in a co-investing strategy?

Co-investing can allow a GP to make larger investments without dedicating too much of the main fund's capital to a single transaction. This also increases diversification benefits.

What impact does co-investing have on the J-curve?

Co-investments are viewed as leading to a reduction of the J-curve effect and improved capital deployment and returns.

Briefly discuss the following regarding the performance of funds of hedge funds compared to that of individual hedge funds. Diversification potential Risk-adjusted return After-fee performance

Diversification potential: FoFs provide significant diversification potential compared to individual hedge funds. Risk-adjusted return: FoFs have slightly lower information ratios. After-fee performance: On average, FoFs underperform individual hedge funds after fees.

Is it possible to identify top-tier hedge fund managers a priori, and do hedge fund managers display significant performance persistence?

Empirical evidence (both from the academia and from the industry) provides mixed results on these issues. For instance, some of the studies suggest that top-tier hedge funds do exhibit return persistence. However, the outperformance of these top-tier hedge funds tends to disappear as time passes and as capital flows to these top-performing funds. Other researchers have not found performance persistence among hedge fund managers, and if they find any, it tends to erode after only a few months.

Pooled Cash Flow IRR

Is arrived at by taking all the individual fund's cash flows as well as their residual values and solving for the IIRR. As a result of the pooling of funds, the results will be skewed in favor of larger funds in the portfolio. *The best measure to use to measure portfolio performance is the pooled measure.

Commodity returns on ETP, why leveraged and inverse ETP don't make $ long term

Leveraged investments include leveraged ETFs and leveraged notes (ETNs) and are used to magnify exposure to the commodity via the use of leverage. Both ETFs and ETNs provide daily leverage and as such returns may different when looking at longer-term leveraged returns. If these instruments are used to generate long-term returns, they will incur significant transaction costs as a result of the need to constantly rebalance in order to earn returns that equal to the long-term index adjusted for leverage. *The long-term term return may end up being negative even though the actual commodity has increased in price.

An endowment investor is in the process of finalizing a side letter as part of their limited partnership agreement with a private equity GP. In the agreement, the investor is requesting to be treated with all other benefits offered to any other LP in the private equity fund. Additionally, the LP has requested anonymity as an investor in the fund. What are the names of these two terms the LP has requested in the side letter?

The LP is requesting a most favored nation status and including a use of name clause in the side letter, respectively

What is the primary benefit of obtaining commodity exposure through derivatives contracts rather than direct physical ownership?

The primary benefit of obtaining commodity exposure through derivatives contracts is the ability to benefit from price changes in the commodity without the need to store it.

Consider an investor with a $30 million allocation to private equity that decides to commit to $45 million of new private equity investments over the next few years. Calculate the Overcommitment Ratio

the Overcommitment Ratio = Total Commitments /Resources Available for Commitments. Therefore, the ratio is $45 million / $30 million = 150%.

Advantages of UNLISTED real estate funds

• Diversification benefits are provided via investors gaining access to a diversified pool of investments. • Skilled managers can generate superior returns at low levels of risk. • Access to exposure to asset classes that the investor would otherwise not have had access to. • Investors can earn tax-exempt income by investing in certain unlisted real estate investments.

List the three major advantages of investing directly with hedge funds

(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.

Why might investors wish to participate in the secondary market over the primary market?

- exposure to PE assets quickly without having to commit capital over a period of 10-12 years. -reduction of risks by using secondaries to diversify their vintage year exposure Secondaries also tend to generate strong IRR performance and can counteract the J-curve effect of primary funds.

Three theories for the increased beta and decreased alpha in hedge fund returns

- fund bubble hypothesis - capacity constraint hypothesis - increased allocation to active funds

Explain why equity of firms that derive a significant part of their revenue from the sale of physical commodities might offer weak exposure to the underlying commodities.

-firms hedge their principal commodity exposures which can affect the degree of commodity exposure the firm provides to investors -evidence that commodity producers engage in selective hedging -in which they actively alter their hedge ratios based on their views of future commodity prices. -public commodity based equities are subject to significant market risk and business risk.

List three alternative co-investing structures

1) the LP invests directly into one or more of the portfolio companies of the main fund, 2) one or more LPs use a GP-controlled fund created apart from the man fund, and 3) making investments in co-investment programs in which the specific investments are identified and decisions of whether to co-invest are made on an ongoing and deal-by-deal basis.

The following two propositions have been put forward which institutional investors should consider when allocating assets via private structures:

1. Private structures should only be used to access asset classes that contained superior investment opportunities and only if highly skilled managers can be identified and accessed. 2. Managers that possess unremarkable skill or managers in markets with modest investment opportunities should only be accessed via listed structures.

A hedge fund of fund manager is constructing his fund-of-fund portfolio using an equal risk-weighted approach. He wants his portfolio weights to be the same as those of a risk-parity portfolio. To accomplish this, what characteristics should the hedge funds in the portfolio have? In addition, state two key drawbacks of constructing equal risk-weighted portfolios.

1pt: For the equal risk-weighted and risk-parity approaches to have the same portfolio weights, the hedge funds should have the same correlation with each other. 1pt each: Drawbacks (state two): - using historical data to allocate capital without considering market changes - not accounting for cross-correlations with other strategies; being very dependent on the time period used - in stressed markets, generating results that may not represent long-term volatility levels. Reminder: The equal risk-weighted approach is also referred to as the inverse-weighting approach.

Explain the fund bubble hypothesis and indicate what it implies about alpha and beta.

1pt: The fund bubble hypothesis states that more investment capital supplied to the hedge fund universe results in more less skilled managers entering the industry and diluting the hedge fund industry's overall performance with their poor returns. 1pt: This implies that alpha declines and beta increases.

According to the 2017 Cambridge Associates report, how did the NCREIF Property Index perform relative to the NAREIT All Equity Index? Provide potential explanations for this relative performance.

1pt: The report found that public real estate (i.e., NAREIT index) outperformed private properties (i.e., NCREIF Property Index). 1pt: The return difference may be partly or fully attributable to differences in the leverage levels used or in the risk of the underlying real estate portfolios.

Define time-zero-based pooling.

1pt: Time-zero-based pooling refers to pooling cash flows across different funds and treating the cash flows as if they all started on the same date (i.e., the funds have the same vintage year). This can help alleviate when there is a large cash inflow late in the life of the fund- it will have little impact on return if the IRR is positive but will have a large impact on return if the IRR is negative.

A private equity fund has a PME ratio of 3.4. Explain what this value indicates about the performance of the private equity fund.

A PME ratio greater than one (0.5pts) indicates that the private fund outperformed the public market index (0.5pts).

How did the Dodd-Frank Act in the United States close the regulatory gap between hedge funds and mutual funds?

After the Dodd-Frank Act, many hedge fund managers had to register as investment advisers. Since a U.S. mutual fund manager must also be registered as an investment adviser, a hedge fund manager can easily launch a U.S. mutual fund once registered.

Disadvantages of Unlisted Real Estate Funds

Disadvantages of unlisted real estate mutual funds include: • Cash drag is an issue as a result of these funds needing to hold a certain amount of cash. This is done so that they can take advantage of real estate opportunities as they become available. • Returns are greatly impacted by commissions, fees and other costs charged by the fund. These fees may be quite high. • As a result of the J-curve, these funds need to earn high returns in the later years in order to make up for the losses in the early years. Based on this, they often make use of leverage, which increases returns but also increases risk.

According to empirical evidence, how do funds of hedge fund (FoFs) compare to single hedge funds in terms of drawdowns, standard deviation of returns, and average returns?

Empirical evidence presented in the book indicates that FoFs have fairly low drawdowns and standard deviations, and lower drawdowns and standard deviations than the average individual hedge fund. However, during the same period (1990-November 2011) average returns on FoFs were only a little more than half of those of individual hedge funds. These results can be explained by the double layer of fees charged by FoFs and by the upward bias in the reported performance of individual hedge funds caused by survivorship bias.

What are the potential benefits of replication products?

Enhancement of absolute and risk-adjusted portfolio returns (and hence they are also named return enhancers). This benefit can arise from: - earning alpha (typically measured relative to the performance of all underlying traditional or alternative beta exposures) - 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. - 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.

Critique the following statement: "Hedge replication products cannot provide alpha because they are not managed by skilled managers."

First of all, and by definition, a replication product will capture the alpha offered by the benchmark (this should be true at least in an extreme case where a replication product can perfectly replicate the return properties of the benchmark). Further, replication products bear lower fees than actively managed portfolios and therefore enhance the possibility of providing alpha to investors who invest in these products. In the end, whether replication products can provide alpha is an empirical question.

What are the three main criticisms that non-traded REITs have received?

First, the illiquidity of non-traded REITs may give the false impression of low return volatility. Second, these types of REITs command high fees and frequently entail significant conflicts of interests. And third, leverage is often used to finance current dividend payments. This practice sometimes conceals their inability to generate future dividends.

What is funding bias?

FoFs discourage bad hedge funds from being launched or, if created, from remaining in business too long. Thus, this phenomenon creates an upward bias in hedge fund returns observed in databases. The existence of funding bias offers an important monitoring and due diligence service for the whole industry. Funding bias should not be confused with reporting biases

While liquidity could be considered a benefit of alternative mutual funds, it is perhaps its biggest risk as well. Why?

Funds may find themselves facing unforeseen redemption requests, which could require them to sell assets that have low liquidity

When it comes to strategy and fund selection, why have institutions historically relied on funds of hedge funds, and how has this changed over time?

Funds of hedge funds historically had preferred access to hedge funds, experienced insight regarding which strategies are likely to outperform going forward, and have reduced the risk of negative headlines should one of the underlying hedge fund investments "blow up." However, the dissemination of hedge fund knowledge and expertise has reduced the value proposition of funds of hedge funds.

What are some of the ways in which private equity GPs can create wealth?

GPs can create wealth through (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.

List the seven major potential advantages of listed assets.

Greater liquidity, lower managerial fees, easier diversification, indications of market values, regulatory oversight, greater access to financing, and tax simplification

Explain why high grade bonds of commodity producing firms offer weaker exposure to commodities than high yield bonds of commodity producing firms.

High grade bonds of commodity producing firms have low sensitivity to the underlying commodity markets. High yield bonds, where the default or political risk is high, are more correlated with the prices of commodities produced by the issuing firms.

An institutional investor's investment team is reviewing the Institutional Limited Partners Association's guiding principles with respect to fund term and structure. They are particularly focused on principles regarding commitment and ownership by the general partner of a private fund. State three of these principles.

ILPA's guiding principles for GP commitment and ownership The GP's equity commitment to the fund should be substantial. The GP's equity should not be transferable. The GP should not co-invest only in selected deals.

Describe the tradeoffs between an LP having too much or too little liquidity on hand regarding cash commitments to GPs.

If a large part of capital remains uninvested or parked in low-returning assets such as Treasury bills, there can be a large performance drag. However, too little liquidity could lead to an increased probability of not meeting a cash commitment.

List the seven major potential advantage of privately organized assets.

Illiquidity premium, more incentivized managers, greater asset targeting by investors, appearance of stable values, greater investor oversight, greater managerial flexibility, tax benefits.

An investor is attempting to quickly gain hedge fund exposure in their portfolios. The investor does not have the ability to directly invest in hedge funds at this time but would still like to gain exposure. What are some of the benefits of investing in liquid alternatives over direct hedge funds?

Liquid alternatives typically provide exposure to hedge funds without some of the major drawbacks of direct investing. Typically they have lower fees, better liquidity, and improved transparency.

. An LP is describing co-investing to one of her colleagues. She states that a blind pool equity fund is the best way to directly invest in a single portfolio company, because it provides a level of anonymity from the management of the portfolio company. Is this a correct statement?

No, she incorrectly defined a blind pool equity fund, which aggregates capital obtained from its partners into a single fund. Typically, this investment mandate does not involved limited partners in deal sourcing.

Other than needing a significant amount of capital, state two other drawbacks associated with physical ownership of commodities.

Other drawbacks of physically owning commodities - state two. Need active management to maintain the value of the commodities. Storing commodities can be expensive and difficult. Prices of physical commodities have not kept up with inflation over the long term.

Discuss the implication of a private equity investor having an over-commitment ratio of 92%.

Over-commitment ratios that are less than 100% (e.g., 92%) indicate that the investor's total commitment is less than the resources available for commitment, (1pt) and this implies that the investor's resources are not being used efficiently (0.5pts).

Reasons PE LPs sell their stakes to strategically reposition their portfolios -

Portfolio management decisions. Poor fund performance (sell so can use the capital in new opportunities). Lock in returns (if underlying portfolio companies are unlikely to increase fund performance during the rest of the fund's lifetime). Reduce the denominator effect by selling illiquid assets (i.e., unintended over-allocation to illiquid assets as illiquid assets in a portfolio increase as the overall portfolio decreases).

In the U.K., what are property unit trusts (PUTs)?

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

Describe some of the differences in risk and return regarding coinvestments and direct investments

Research has found that direct investments have significantly outperformed co-investments and industry-standard benchmarks. Coinvestments may be associated with higher risk deals.

Define return to commodity beta.

Return to commodity beta is the return due to changes in commodity prices resulting from holding a passive long commodity position.

Define roll return in the context of commodity futures investments.

Roll return, or roll yield, is the portion of the return to a futures contract that is due to the change in basis.

State the five services provided by the delegated approach to gaining hedge fund exposure.

Sourcing managers Due diligence Strategy and fund selection Portfolio construction Risk management and monitoring

With respect to tax status, redemption price, life of fund, and types of real assets held, describe unlisted open-end and closed-end real estate funds.

Tax status Open-end: tax-free for qualifying pension funds. Closed-end: tax-neutral limited partnerships. Redemption price Open-end: based on funds' appraised properties. Closed-end: based on funds' properties' proceeds at the termination date. Life of fund Open-end: indefinite; closed-end: finite. Types of real assets held Open-end: low-risk or core real estate. Closed-end: high-risk private equity real estate funds.

How does the capacity constraint hypothesis explain the general rise in the beta of hedge fund indices and the corresponding decline in their alphas during the past two decades?

The capacity constraint hypothesis asserts that alpha is essentially a zero-sum game and that, therefore, only a few managers can be expected to consistently deliver alpha. The per capita amount of alpha available in the marketplace has declined substantially with AUM growing almost exponentially since the early 1990s. According to this hypothesis, alpha will be expected to continue to decline unless new sources of alpha are discovered.

Describe the evolution of secondary market pricing in terms of discount to NAV since 2009.

The discount to NAV has decreased since 2009 across all strategies

State four ways in which commodity-based exchange traded notes (ETNs) are different from commodity-based exchange traded funds (ETFs).

The four ways are: i. ETNs are zero coupon instruments ii. The return to the ETN is subject to the credit-worthiness of the issuer iii. The price of the ETN is based on a contractually designated relationship with the underlying index iv. ETNs may qualify for capital gains tax treatment if held for a sufficiently long period of time

How does the fund bubble hypothesis explain a general rise in the beta of hedge fund indices and the corresponding decline in their alphas?

The fund bubble hypothesis assumes that skilled hedge fund managers can earn substantially superior returns than successful fund managers in the traditional space. This hypothesis asserts that the number of less qualified managers in the hedge fund industry increases with the supply of capital to hedge funds. The correspondingly inferior returns provided by these new hedge funds dilute the aggregate industry performance.

State the ILPA's guidelines regarding a private fund's fee income beyond the management fee.

The guideline is that no fee should be charged to the fund's portfolio companies. Side note (not in curriculum): The guidance is that no fees should be charged to portfolio companies. However, the guidelines also state that, if fees are charged to portfolio companies, the fees should be disclosed and should be 100% offset against the management fee.

How does the increased allocation to active funds hypothesis explain the general rise in the beta of hedge fund indices and the corresponding decline in their alphas during the past two decades?

The increased allocation to active funds hypothesis argues that as investments in hedge funds becomes more popular; the aggregate performance of the industry will be adversely affected by the decisions of investors who have allocations to these funds as well as to traditional assets. In other words, the systematic risks or betas of hedge funds will increase as more capital flows into the industry. For instance, during periods of financial market turmoil, investors may be forced to liquidate both their traditional and their alternative investments, increasing the correlation between these two asset classes.

In the context of obtaining commodity exposure, what are three major drawbacks of over-the-counter commodity index swaps?

The main drawbacks of commodity index swaps are: • 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

What is the primary vehicle used by institutional investors to obtain indirect commodity exposure?

The primary vehicle used by institutional investors for obtaining exposure to commodity indices is commodity index swaps

What is the principal advantage of master limited partnership (MLP) structures in obtaining commodity exposure?

The principal advantage of master limited partnership (MLP) structures is in avoiding corporate taxation. Income from qualifying MLPs is distributed directly to investors.

Define the return to commodity beta

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

How has the evolution of the secondary private equity market evolved in terms of the rationale for investor participation?

The secondary market was initially viewed as a market of last resort for LPs wishing to sell their PE fund interests. However, the market has matured and large institutions regularly exit from private equity as part of an overall portfolio management and reallocation strategy.

List the six advantages of LISTED Real Estated Funds

The six advantages of listed real estate funds are: • They help diversify real estate specific risk (similar to the case of unlisted real estate funds). • These types of funds are liquid and divisible. • They provide instant exposure to a real estate portfolio. • They convey information to the investors. • Some listed real estate funds allow the targeting of subsectors or regions (similar to the case of unlisted real estate funds). • They provide tax benefits, such as exemption from corporate taxes (similar to the case of unlisted real estate funds).

What is the underlying assumption behind the factor-based approach?

The underlying assumption behind the factor-based approach is that a set of asset-based factors can explain a significant portion of a fund's returns.

State the underlying assumption of the factor-based approach to hedge fund replication.

The underlying assumption is that a substantial portion of a hedge fund's returns can be explained by asset-based factors (0.5pts) such that constructing a portfolio of long and/or short positions in a set of risk factors can minimize the tracking error with respect to the benchmark being replicated (1pt).

List the disadvantages associated with co-investing

Unbalanced portfolios, increased fiduciary risk, conflicts of interest, disagreements among LPs, allocation of fees.

Why do unlisted real estate funds suffer from cash drag?

Unlisted real estate funds suffer from cash drag because cash invested by investors in these types of funds will most likely not be drawn by the fund manager right away. Instead, cash will be drawn from investors as it is required by the fund to buy real estate assets. As a result, investors will not attain immediate full exposure to real estate assets when they provide cash to unlisted real estate funds.

Does use of a subscription-secured line of credit by a successful private equity fund generally increase or decrease the fund's internal rate of return?

Use of a subscription-secured line of credit (SLOC) improves a fund's IRR. Not needed for response: Using a SLOC delays capital calls or serves as a substitute for capital from fund limited partners (LPs). This essentially reduces the length of time that the LPs' capital is deployed. The IRR is increased for funds that perform well; and becomes more negative for poorly-performing funds.

Describe a use of name clause.

Use of name clauses may be used in side letter agreements in private partnerships to limit disclosure of a fund investor's identity by the fund sponsor (1pt), subject to limits imposed on the sponsor (e.g., requirement to disclose identity when reporting to regulators) (0.5pts). Side note: I.e., the clause states the extent to which investors names may be used, thus providing investors some anonymity.

Discuss database biases and the quality of data in commercial fund of hedge fund databases compared to those in individual hedge fund databases.

While many individual hedge fund databases are exposed to several database biases (e.g., selection, survivorship, and instant history), FoF databases have little/no exposure to these biases. Little or no hedge fund survivorship bias - FoFs do not remove from their history the historical returns of hedge funds that stop reporting to databases. No hedge fund selection bias - FoFs include the performance of all hedge funds in which they invest. No instant history bias - FoFs do not backfill the performance of new hedge funds. Less survivorship bias -FoFs have a lower mortality rate than individual hedge funds.