CFA Level 1 Part 2 (Alternative Investments)

Fill in the blanks: Adding real estate to a portfolio has been demonstrated to increase portfolio ___________ and reduce portfolio ___________.

Adding real estate to a portfolio has been demonstrated to increase portfolio DIVERSIFICATION and reduce portfolio RISK.

Which of the following forms of infrastructure investment is the most liquid? A An unlisted infrastructure mutual fund B A direct investment in a greenfield project C An exchange-traded MLP

C is correct. A publicly traded infrastructure security, such as an exchange-traded MLP, provides the benefit of liquidity.

An investor with limited investment and due diligence experience will most likely invest in alternative assets using which method? A Fund investing B Co-investing C Direct investing

A is correct. An investor with limited investment and due diligence experience will likely choose fund investing to benefit from the expertise that a fund man- ager would provide.

Fill in the blanks with the correct words: An American waterfall distributes performance fees on a(n) ___________ basis and is more advantageous to the ___________. A deal-by-deal; LPs B aggregate fund; LPs C deal-by-deal; GP

C is correct. American waterfalls, also known as deal-by-deal waterfalls, pay performance fees after every deal is completed and are more advantageous to the GP because they get paid sooner (compared with European, or whole-of- fund, waterfalls).

Fill in the blank: Compared with private real estate investing, publicly traded real estate investment trusts provide much greater ___________, lower ___________, and better ___________. Choices of words: transparency, liquidity, trading costs, variety, happiness

Compared with private real estate investing, publicly traded real estate investment trusts provide much greater LIQUIDITY, lower TRADING COST, and better TRANSPARENCY.

The distribution method by which profits generated by a fund are allocated between LPs and the GP is called: A a waterfall. B an 80/20 split. C a fair division.

A is correct. Although profits are typically split 80/20 between LPs and the GP, the distribution method of profits is not called an "80/20 split." "Fair division" is not a real term that exists in the industry.

Risks in infrastructure investing are most likely greatest when the project involves: A construction of infrastructure assets. B investment in existing infrastructure assets. C investing in assets that will be leased back to a government.

A is correct. Infrastructure projects involving construction have more risk than investments in existing assets with a demonstrated cash flow or investments in assets that are expected to generate regular cash flows.

Both event-driven and macro hedge fund strategies use: A long-short positions. B a top-down approach. C long-term market cycles.

A is correct. Long-short positions are used by both types of hedge funds to potentially profit from anticipated market or security moves. Event-driven strategies use a bottom-up approach and seek to profit from a catalyst event typically involving a corporate action, such as an acquisition or a restructuring. Macro strategies seek to profit from expected movements in evolving economic variables.

Which approach is most commonly used by equity hedge strategies? A Top down B Bottom up C Market timing

B is correct. Most equity hedge strategies use a bottom-up strategy.

A private equity fund desiring to realize an immediate and complete cash exit from a portfolio company is most likely to pursue: (2020 Q18) A an IPO. B a trade sale. C a recapitalization.

B is correct. Private equity funds can realize an immediate cash exit in a trade sale. Using this strategy, the portfolio company is typically sold to a strategic buyer.

In direct investing, an investor puts capital in an asset or business: A using a special purpose vehicle, such as a fund. B using a separate business entity, such as a joint venture. C without the use of an intermediary.

C is correct. Direct investing occurs when an investor makes a direct investment in an asset without the use of an intermediary.

As the loan-to-value ratio increases for a real estate investment, risk most likely increases for: (2020 Q19) A debt investors only. B equity investors only. C both debt and equity investors.

C is correct. The higher the loan-to-value ratio, the higher leverage is for a real estate investment, which increases the risk to both debt and equity investors. RISK DECREASES FOR BANK???

Which of the following performance measures uses beta as the risk measure? A Sharpe ratio B Treynor ratio C Sortino ratio

The correct answer is B. Both Sharpe Ratio and Sortino Ratio use standard deviation as a risk measure. Treynor ratio uses beta as a risk measure.

What is the most significant drawback of a repeat sales index to measure returns to real estate? (2020 Q14) A Sample selection bias B Understatement of volatility C Reliance on subjective appraisals

A is correct. A repeat sales index uses the changes in price of repeat sales prop- erties to construct the index. Sample selection bias is a significant drawback because the properties that sell in each period vary and may not be representative of the overall market the index is meant to cover.

Hedge fund losses are most likely to be magnified by a: A margin call. B lockup period. C redemption notice period.

A is correct. Margin calls can magnify losses. To meet the margin call, the hedge fund manager may be forced to liquidate a losing position in a security, which, depending on the position size, could exert further price pressure on the security, resulting in further losses. Restrictions on redemptions, such as lockup and notice periods, may allow the manager to close positions in a more orderly manner and minimize forced-sale liquidations of losing positions.

Hedge funds are similar to private equity funds in that both: A are typically structured as partnerships. B assess management fees based on assets under management. C do not earn an incentive fee until the initial investment is repaid.

A is correct. Private equity funds and hedge funds are typically structured as partnerships where investors are limited partners and the fund is the general partner. The management fee for private equity funds is based on committed capital, whereas for hedge funds, the management fees are based on assets under management. For most private equity funds, the general partner does not earn an incentive fee until the limited partners have received their initial investment back.

A hedge fund with a market-neutral strategy restricts its investment universe to domestic publicly traded equity securities that are actively traded on an exchange or between over-the-counter brokers. In calculating net asset value, the fund is most likely to use which of the following to value underlying positions? A Exchange last-trade pricing and/or averaged quotes of any available over- the-counter bid-offer spreads B Average quotes adjusted for liquidity C Bid price for shorts and ask price for longs

A is correct. The fund is most likely to use exchange-traded last-trade pricing (Level 1 pricing) or averaged quotes of publicly available bid-offer spreads (Level 2 pricing). The securities are actively traded, so no liquidity adjustment is required.

The first stage of financing at which a venture capital fund most likely invests is the: (2020 Q13) A seed stage. B mezzanine stage. C angel investing stage.

A is correct. The seed stage supports market research and product development and is generally the first stage at which venture capital funds invest. The seed stage follows the angel investing stage. In the angel investing stage, funds are typically provided by individuals (often friends or family), rather than a venture capital fund, to assess an idea's potential and to transform the idea into a plan. Mezzanine-stage financing is provided by venture capital funds to prepare the portfolio company for its IPO. TRICK QUESTION

An investor seeks a current income stream as a component of total return and desires an investment that historically has low correlation with other asset classes. The investment most likely to achieve the investor's goals is: (2020 Q10) A timberland. B collectibles. C commodities.

A is correct. Timberland offers an income stream based on the sale of timber products as a component of total return and has historically generated returns not highly correlated with other asset classes.

Which of the following relates to a benefit when owning real estate directly? A Taxes B Capital requirements C Portfolio concentration

A is correct. When owning real estate directly, there is a benefit related to taxes. The owner can use property non-cash depreciation expenses to reduce taxable income and lower the current income tax bill. SOMEWHAT A TRICK QUESTION MUST KNOW FOR EXAM

Fill in the blank by choosing from among the following options:___________ is an infrastructure investment characteristic most likely valuable to investors aiming to sell newly constructed assets to the government. A "Strategically important" B "Monopolistic and regulated" C "Significant capital investment"

A is the correct answer because the related priority will probably increase the demand of the public buyer to effectively provide essential services to its citizens.

An investor chooses to invest in a brownfield, rather than a greenfield, infra- structure project. The investor is most likely motivated by: A growth opportunities. B predictable cash flows. C higher expected returns.

B is correct. A brownfield investment is an investment in an existing infrastruc- ture asset, which is more likely to have a history of steady cash flows compared with that of a greenfield investment. Growth opportunities and returns are expected to be lower for brownfield investments, which are less risky than greenfield investments.

An investor in a private equity fund is concerned that the general partner can receive incentive fees in excess of the agreed-on incentive fees by making distri- butions over time based on profits earned rather than making distributions only at exit from investments of the fund. Which of the following is most likely to protect the investor from the general partner receiving excess fees? (2020 Q32) A A high hurdle rate B A clawback provision C A lower capital commitment

B is correct. A clawback provision requires the general partner in a private equity fund to return any funds distributed (to the general partner) as incentive fees until the limited partners have received their initial investments and the contracted portion of the total profits. A high hurdle rate will result in distributions occur- ring only after the fund achieves a specified return. A high hurdle rate decreases the likelihood of, but does not prevent, excess distributions. Management fees, not incentive fees, are based on committed capital.

A significant challenge to investing in timber is most likely its: A high correlation with other asset classes. B dependence on an international competitive context. C return volatility compounded by financial market exposure.

B is correct. A primary risk of timber is the international competitive landscape. Timber is a globally sold and consumed commodity subject to world trade interruptions. So the international context can be considered one of its major risk factors.

Fill in the blank by choosing from among the following options:___________ is the type of private debt expected to have the greatest excess return potential. A Unitranche B Mezzanine C Infrastructure

B is correct. As a junior form of subordinated debt, mezzanine private debt private debt offers higher growth potential, equity upside, and higher risk, with the comparatively highest returns. Infrastructure debt is senior and poses the lowest risk. Unitranche debt is less risky than subordinated debt but riskier than infrastructure debt and is a blend of secured and unsecured debt; its interest rate generally falls in between the interest rates often demanded on secured and unsecured debt, and the loan itself is usually structured between senior and subordinated debt.

In comparison to other alternative investment approaches, co-investing is most likely: A more expensive. B subject to adverse selection bias. C the most flexible approach for the investor.

B is correct. Co-investing may be subject to adverse selection bias. For example, the fund manager may make less attractive investment opportunities available to the co-investor while allocating its own capital to more appealing deals.

If a commodity's forward curve is downward sloping and there is little or no convenience yield, the market is said to be in: A backwardation. B contango. C equilibrium.

B is correct. Contango is a condition in the futures markets in which the spot price is lower than the futures price, the forward curve is upward sloping, and there is little or no convenience yield. LITTLE CONVENIENCE YEILD = CONTANGO

Relative to co-investing, direct investing due diligence is most likely: A harder to control. B more independent. C equally thorough.

B is correct. Direct investing due diligence may be more independent than that of co-investing because the direct investing team is typically introduced to opportunities by third parties rather than fund managers, as is customary in co-investing.

Angel investing capital is typically provided in which stage of financing? (2020 Q24) A Later stage B Formative stage C Mezzanine stage

B is correct. Formative-stage financing occurs when the company is still in the process of being formed and encompasses several financing steps. Angel investing capital is typically raised in this early stage of financing.

The privatization of an existing hospital is best described as: A a greenfield investment. B a brownfield investment. C an economic infrastructure investment.

B is correct. Investing in an existing infrastructure asset with the intent to privatize, lease, or sell and lease back the asset is referred to as a brownfield investment. An economic infrastructure asset supports economic activity and includes such assets as transportation and utility assets. Hospitals are social infrastructure assets, which are focused on human activities.

Private capital is: A accurately described by the generic term "private equity." B a source of diversification benefits from both debt and equity. C predisposed to invest in both the debt and equity of a client's firm.

B is correct. Investments in private capital funds can add diversity to a portfolio composed of publicly traded stocks and bonds because they have less-than- perfect correlation with those investments. There is also the potential to offer further diversification within the private capital asset class. For example, private equity investments may also offer vintage diversification since capital is not deployed at a single point in time but is invested over several years. Private debt provides investors with the opportunity to diversify the fixed-income portion of their portfolios since private debt investments offer more options than bonds and other public forms of traditional fixed income.

Compared with direct investment in infrastructure, publicly traded infrastructure securities are characterized by: A higher concentration risk. B more transparent governance. C greater control over the infrastructure assets.

B is correct. Publicly traded infrastructure securities, which include shares of companies, exchange-traded funds, and listed funds that invest in infrastructure, provide the benefits of transparent governance, liquidity, reasonable fees, market prices, and the ability to diversify among underlying assets.

Which of the following statements is true for REITs? A According to GAAP, equity REITs are exempt from reporting earnings per share. B Though equity REIT correlations with other asset classes are typically moderate, they are highest during steep market downturns. C The REIT corporation pays taxes on income, and the REIT shareholder pays taxes on the REIT's dividend distribution of after-tax earnings.

B is correct. Real estate investments, including REITs, provide important portfolio benefits due to moderate correlation with other asset classes. However, there are periods when equity REIT correlations with other securities are high, and their correlations are highest during steep market downturns.

Which of the following is not considered a strategy in private debt investing? A Direct lending B Recapitalization C Mezzanine debt

B is correct. Recapitalization is when a private equity firm increases leverage or introduces it to the company and pays itself a dividend. 4 Types FOR DEBT are... Direct Lending Venture Debt Mezzanine Loans Distressed Debt

The Sharpe ratio is a less-than-ideal performance measure for alternative investments because: A it uses a semi-deviation measure of volatility. B returns of alternative assets are not normally distributed. C alternative assets exhibit low correlation with traditional asset classes.

B is correct. The Sharpe ratio assumes normally distributed returns. However, alternative assets tend to have non-normal return distributions with significant skewness (fat tails in one direction or the other) and kurtosis (sharper peak than a normal distribution has, with fatter tails). Therefore, the Sharpe ratio may not be a good risk-adjusted performance measure to rely on for alternative investments.

Which of the following is true regarding private equity performance calculations? A The money multiple calculation relies on the amount and timing of cash flows. B The IRR calculation involves the assumption of two rates. C Because private equity funds have low volatility, accounting conventions allow them to use a lagged mark-to-market process.

B is correct. The determination of an IRR involves certain assumptions about a financing rate to use for outgoing cash flows (typically a weighted average cost of capital) and a reinvestment rate assumption to make on incoming cash flows (which must be assumed and may or may not actually be earned).

Private equity funds are most likely to use: A merger arbitrage strategies. B leveraged buyouts. C market-neutral strategies.

B is correct. The majority of private equity activity involves leveraged buyouts. Merger arbitrage and market neutral are strategies used by hedge funds.

The majority of real estate property may be classified as either: A debt or equity. B commercial or residential. C direct ownership or indirect ownership.

B is correct. The majority of real estate property may be classified as either commercial or residential.

A characteristic of farmland strongly distinguishing it from timberland is its: A commodity price-driven returns. B inherent rigidity of production for output. C value as an offset to other human activities.

B is correct. Unlike timberland products, farm products must be harvested when ripe, so there is little flexibility in the production process. In contrast, timber (trees) can be grown and easily "stored" by simply not harvesting. This feature offers the flexibility of harvesting more trees when timber prices are up and delaying harvests when prices are down.

Until the committed capital is fully drawn down and invested, the management fee for a private equity fund is based on: (2022 Q33) A invested capital. B committed capital. C assets under management.

B is correct. Until the committed capital is fully drawn down and invested, the management fee for a private equity fund is based on committed capital, not invested capital. Private Equity -> Committed Capital Hedge Fund -> Assets under management

True or false: The largest sector of the real estate market by value and size is commercial real estate. A True, statement to support this option on why it's true. B False, statement to support this option on whey it's false.

B is correct; the statement is false. Residential real estate is by far the largest sector of the real estate market by value and size. The residential debt market greatly exceeds commercial property debt because of the larger total value of residential properties combined with property owners' greater ability to use lever- age—up to 80% of the property's value or more in some cases. In addition, home mortgages are subsidized in some markets, including government guarantees.

Is the following statement true or false? The Sharpe and Sortino ratios share the same denominator. A True, statement to support this option on why it's true. B False, statement to support this option on why it's false.

B is correct; the statement is false. The Sharpe and Sortino ratios share the same numerator—average annualized return net of the risk free-rate. Their denomi- nators are different. The denominator for the Sharpe ratio is standard deviation of returns, and the denominator for the Sortino ratio is downside deviation of returns—a semi-deviation measure of volatility only during periods of loss for an alternative investment.

True or false: The Sharpe ratio measures the amount of risk per unit of return. A True, statement to support this option on why it's true. B False, statement to support this option on why it's false.

B is correct; the statement is false. The Sharpe, Sortino, and Treynor ratios are risk-adjusted performance measurements. They are measures of return per unit of risk.

Is the following statement true or false?For the most appropriate instrument to invest in natural resources today, retail investors should focus on the stocks and bonds of companies producing in this sector. A True, statement to support this option on why it's true. B False, statement to support this option on why it's false.

B is correct; the statement is false. Up to about 20 years ago, the only commonly available investment vehicles related to this asset class were indeed financial instruments (stocks and bonds). Rather than investing in the physical land and the products that come from it, investors concentrated on the companies that produced natural resources. Nowadays, however, the wide variety of direct investments via ETFs, limited partnerships, REITS, swaps, and futures opens the door for almost everyone to participate in these assets directly.

Large institutional investors consider timberland investments because: A The small parcel sizes permit fine tuning of their holdings across geogra- phy and wood types. B The optionality around harvesting gives investors the choice between cutting trees for lumber and current income or letting them grow another year for future gain. C The short return history allows for many alpha opportunities by knowl- edgeable active managers. D Clear-cutting trees and destroying nature is appreciated by ESG investors, which are becoming a larger portion of the investment universe.

B is the correct answer. THE OPTIONALITY AROUND...

A collateralized loan obligation specialist is most likely to: A sell its debt at a single interest rate. B cater to niche borrowers in specific situations. C rely on diverse risk profiles to complete deals.

C is correct. A CLO manager will extend several loans to corporations (usually to firms involved in LBOs, corporate acquisitions, or other similar types of transactions), pool these loans, and then divide that pool into various tranches of debt and equity that range in seniority and security. The CLO manager will then sell each tranche to different investors according to their risk profiles; the most senior portion of the CLO will be the least risky, and the most junior portion of the CLO (i.e., equity) will be the riskiest. PRIVATE DEBT LEVERAGED LOAN

An alternative investment fund's hurdle rate is a: A rate unrelated to a catch-up clause. B tool to protect clients from paying twice for the same performance. C minimum rate of return the GP must exceed in order to earn a perfor- mance fee.

C is correct. An alternative investment fund's hurdle rate is a minimum rate of return the GP must exceed in order to earn a performance fee. A is incorrect because if a catch-up clause is included in the partnership agreement, the catch-up clause permits distributions in relation to the hurdle rate. B is incorrect because it is a high-water mark (not a hurdle rate) that protects clients from paying twice for the same performance.

Which of the following forms of debt are likely to have additional features, such as warrants or conversion rights? A Mezzanine debt B Venture debt C Both A and B

C is correct. Both mezzanine and venture debt are likely to have additional features, such as warrants and conversion rights, to compensate debt holders for increased risk, including the risk of default.

Which of the following statements about commodity investing is invalid? A Few commodity investors trade actual physical commodities. B Commodity producers and consumers both hedge and speculate. C Commodity indexes are based on the price of physical commodities.

C is correct. Commodity indexes typically use the price of futures contracts on the commodities included in them rather than the prices of the physical commodities themselves in order to be transparent, investable, and replicable.

An analyst wanting to assess the downside risk of an alternative investment is least likely to use the investment's: (2020 Q34) A Sortino ratio. B value at risk (VaR). C standard deviation of returns.

C is correct. Downside risk measures focus on the left side of the return distri- bution curve, where losses occur. The standard deviation of returns assumes that returns are normally distributed. Many alternative investments do not exhibit close-to-normal distributions of returns, which is a crucial assumption for the validity of a standard deviation as a comprehensive risk measure. Assuming normal probability distributions when calculating these measures will lead to an underestimation of downside risk for a negatively skewed distribution. Both the Sortino ratio and the VaR measure are measures of downside risk.

The investment method that typically requires the greatest amount of or most thorough due diligence from an investor is: A fund investing. B co-investing. C direct investing.

C is correct. Due diligence in direct investing will usually be more thorough and more rigid from an investor's perspective because of the absence of a fund man- ager that would otherwise conduct a large portion of the necessary due diligence.

From the perspective of the investor, the most active approach to investing in alternative investments is: A co-investing. B fund investing. C direct investing.

C is correct. From the perspective of the investor, direct investing is the most active approach to investing because of the absence of fund managers and the services and expertise they generally provide.

An equity hedge fund following a fundamental growth strategy uses fundamental analysis to identify companies that are most likely to: (2022 Q16) A be undervalued. B be either undervalued or overvalued. C experience high growth and capital appreciation.

C is correct. Fundamental growth strategies take long positions in companies identified, using fundamental analysis, to have high growth and capital appreci- ation. Fundamental value strategies use fundamental analysis to identify under- valued companies. Market-neutral strategies use quantitative and fundamental analysis to identify under- and overvalued companies.

An investor may prefer a single hedge fund to a fund of funds if she seeks: (2022 Q8) A due diligence expertise. B better redemption terms. C a less complex fee structure.

C is correct. Hedge funds of funds have multi-layered fee structures, whereas the fee structure for a single hedge fund is less complex. Funds of funds presumably have some expertise in conducting due diligence on hedge funds and may be able to negotiate more favorable redemption terms than an individual investor in a single hedge fund could.

Which is not true of mark-to-model valuations? A Return volatility may be understated. B Returns may be smooth and overstated. C A calibrated model will produce a reliable liquidation value.

C is correct. It is not true that a calibrated model will produce a reliable liquidation value in a mark-to-model valuation. The need to use a model for valuation arises when an asset is so illiquid that there are not reliable market values available. A model may reflect only an imperfect theoretical valuation, not a true liquidation value, should liquidation become necessary. The illiquid nature of alternative assets means that estimates, rather than observable transaction prices, may have been used for valuation purposes.

Which of the following statements is true regarding mortgage-backed securities? A Insurance companies prefer the first-loss tranche. B When interest rates rise, prepayments will likely accelerate. C When interest rates fall, the low-risk senior tranche will amortize more quickly.

C is correct. When interest rates decline, borrowers are likely to refinance their loans at a faster pace than before, resulting in faster amortization of each MBS tranche, including the senior tranche, which is the lowest-risk tranche.

Fill in the blank: Investments in limited partnerships are ___________ regulated than offerings to the general public.

Investments in limited partnerships are LESS regulated than offerings to the general public.

Alexandra is considering buying a tract of farmland for long-term capital appreciation and current income. Which of the following factors play a role in evaluating the attractiveness of the investment? A The land's rights to preferential water access B The land's proximity to a large, privately held nature reserve C The land's soil chemical composition allowing the growth of a variety of crops D All of the above

The answer is D. ALL OF THE ABOVE

Fill in the blank: The goal of hedge fund redemption restrictions is typically to ___________ manager flexibility.

The goal of hedge fund redemption restrictions is typically to INCREASE hedge fund manager flexibility.

Identify two of the four stages of the private equity continuum and the company growth stage each finances.

The stages of the entire PE continuum and their associated growth stage financ- ing are as follows: 1 Venture capital focuses on start-up and seed-stage businesses. 2 Growth equity focuses on more established businesses. 3 Recapitalizations focus on more mature businesses, either healthy or distressed. 4 Buyouts/LBOs focuses on mature businesses

Fill in the blank: A ___________ fee is typically added to a management fee for a fund governed by a limited partnership agreement.

A performance (incentive or carried interest) fee is typically added to a management fee for a fund governed by a limited partnership agreement.

The minimum rate of return that a GP must exceed in order to earn an incentive or performance fee is called the: A high-water mark. B hurdle rate. C performance threshold.

B is correct (Hurdle Rate) ... A high-water mark is the highest value used to calculate an incentive fee. "Performance threshold" is not a term that is generally used in the industry.

True or false: In co-investing, the investor is able to invest both directly and indirectly in the same assets.

True. A is correct. In co-investing, the investor is able to invest both directly and indirectly in the same assets.

Which of the following can be considered as an investment in the commodities asset class? A A set of rare antique coins, some of which are made of silver and gold B A lease on an oil tanker shipping oil between Saudi Arabia and China C Ownership of a battery factory that uses industrial metals D A metric tonne of coffee packed in jute bags in a warehouse in Brazil

D is correct, assuming the investor owns the commodity directly, not via a derivatives contract. A describes an investment in collectables (whose value has more to do with the rarity of the collectible rather than the actual value of the silver or gold). B describes a financial contract—effectively, a lease or bond. C is also a financial contract that pays on the use of commodities but depends on many other factors (technology, marketing, rent, and employees) for returns.