Unit 11
Which of the following statements regarding hedge funds is correct? A) Hedge funds are usually structured as a partnership. B) Hedge fund managers, like mutual fund managers, are compensated largely based on assets under management. C) Hedge funds are passively managed in an attempt to provide predictable returns for investors. D) Hedge funds are typically favored by inexperienced investors to hedge against losses they may experience as they gain investment savvy.
A) Hedge funds are usually structured as a partnership. Hedge funds are usually structured as a partnership, with the general partner as the investment manager and the investors as limited partners. Hedge funds are actively and aggressively managed, seeking superior returns, and they are best suited for wealthy, sophisticated investors. Under the typical 2% + 20% fee schedule, hedge fund managers are largely compensated for performance, not assets under management.
Compared to U.S. government agency-backed CMOs, CDOs have A) less prepayment risk. B) greater liquidity. C) generally more secure collateral. D) less credit risk.
A) less prepayment risk. Although there is some prepayment risk with CDOs, it is minimal when compared to CMOs. Unlike mortgages, which are frequently paid off early when homeowners move, those who move can take their cars or their credit cards with them and continue to make the payments. The same is true with refinancing. You don't see ads for people to refinance their auto loan to the extent you do with home mortgages. In general, CDOs carry greater credit risk than CMOs backed by FHA and VA loans. The nature of CDOs, with the enormous variety of collateral options available, means that the liquidity of separate offerings tends to be less than that of these CMOs. Both of these are complex securities, but the experts in the field consider CMOs to be somewhat more so. The credit quality of government-insured mortgages is more secure than that of credit card debt or automobile loans.
Which of the following statements best describes a hedge fund? A) A closed-end investment company employing leverage through the use of debt and preferred stock financing B) An investment pool that is generally unregistered and that, through the use of sophisticated market tools, offers investors returns that generally exceed those available elsewhere C) A private and unregistered investment pool that accepts the investor's money and employs sophisticated hedging and arbitrage techniques using long and short positions, leverage and derivatives, and investments in many markets D) An investment company, registered under the Investment Company Act of 1940, that charges higher than usual management fees and employs sophisticated investment techniques in an attempt to provide level returns during periods of market uncertainty
C) A private and unregistered investment pool that accepts the investor's money and employs sophisticated hedging and arbitrage techniques using long and short positions, leverage and derivatives, and investments in many markets Hedge funds are not registered with the SEC (their managers generally are), and they are invariably sold in private offerings, usually under Regulation D of the Securities Act of 1933. Hedging and arbitrage techniques using long and short positions, leverage and derivatives, and investments in many markets are some of the primary techniques used by these funds. Although some hedge funds do outperform the market, a blanket statement cannot be made.
Which of the following is not a characteristic of hedge funds? A) They invest in private securities, real assets, derivatives, and structured products. B) They are privately organized and generally unregistered. C) They offer managers high fixed fees. D) They use leverage, short positions, and concentrated positions.
C) They offer managers high fixed fees. Hedge funds attempt to attract the top managers because they offer performance-based fees, which vary based on fund performance. The typical fee structure is 2% + 20%, where 2% is the fixed fee and 20% of the profits is the performance portion.
A structured instrument known as an asset-backed security would not be backed by A) student loans. B) credit card debt. C) loans on marginable securities. D) auto loans.
C) loans on marginable securities. One common theme uniting asset-backed securities is the contractual obligation to make payments. In the case of a margin account, there is no repayment schedule. The margin debt can exist for years with the only payment being that of interest.
Which of the following mortgage-backed securities would provide investors with the most predictable maturity date? A) Ginnie Maes B) TACs C) Fannie Maes D) PACs
D) PACs PACs are planned amortization class CMOs and have established maturity dates. Prepayment risk is transferred to the PAC companion, or support, class bonds.
A client is reading some literature about an investment and notices the phrase "2 & 20." The topic of the literature must be A) a leveraged ETF. B) the front-end load and expenses of a Class A share of a mutual fund. C) a direct participation program. D) a hedge fund.
D) a hedge fund. Hedge fund fees are generally based on performance and are higher than those of most other investments. The "2 & 20" refers to a base fee of 2% of the assets plus a 20% of the profits incentive fee.
Which of the following investments is most likely to have extension risk? A) A CMO B) A zero-coupon bond C) A mortgage bond D) A hedge fund
A) A CMO Extension risk is the uncertainty that a debt will be paid off ahead of schedule. This happens most frequently with mortgage-backed securities, such as CMOs. A CMO's yield and maturity are estimates based on historical data or projections of mortgage prepayments from the Public Securities Association (PSA). When that estimate is incorrect and the mortgage prepayments decline (such as in a period of rising interest rates), yields turn out to be lower than projected. Bonds do not have their maturity dates extended, so there is no extension risk.
Which of the following risk factors would be least important to disclose in recommending collateralized mortgage obligation (CMO) securities to public customers? A) Prepayment risk B) Credit risk C) Extended payment risk D) Interest rate risk
B) Credit risk Most CMOs offered to the public are backed by mortgages held by government-sponsored corporations like Fannie Mae, Ginnie Mae, Freddie Mac, et cetera. Credit risk would be a minimal consideration. The other risks are inherent to mortgage-backed securities.
A client interested in the returns offered by CMOs asks you which type has the lowest prepayment risk. What should you say? A) TACs B) PACs C) Plain vanilla D) Z-tranche
B) PACs Although there can be exceptions, in general, the planned amortization class (PAC) has the lowest prepayment risk. The Z-tranche is the most unpredictable because it is paid off only after all of the other tranches.
A characteristic of hedge funds that would not be found in a mutual fund is A) the ability to be purchased on margin. B) a lock-up period. C) a diversified portfolio. D) professional management.
B) a lock-up period. Hedge funds generally employ a lock-up provision. This is to ensure that capital invested by shareholders will remain with the fund long enough for the manager to implement the intended fund strategy. There is no standard lock-up period; it can differ from fund to fund. It should always be noted that during the lock-up period, the investment is essentially rendered illiquid. Hedge funds and mutual funds have professional management and diversified portfolios. Although hedge funds can use margin in portfolio transactions, they, like mutual funds, cannot be purchased on margin.
A customer of a registered representative is considering a hedge fund investment and asks what the lock-up period means? The registered representative correctly explains that it is A) the length of time required to have the hedge fund registered with the SEC, during which time, the fund may not sell any shares. B) a time when liquidation of fund shares is prohibited by the fund, meaning there is an element of illiquidity to be considered. C) the minimum length of time the hedge fund portfolio manager intends to hold any single investment within the portfolio. D) a time when the fund manager will not make any changes (purchases or sales) within the hedge fund portfolio.
B) a time when liquidation of fund shares is prohibited by the fund, meaning there is an element of illiquidity to be considered. Hedge funds generally employ a lock-up provision to ensure that capital invested by shareholders will remain with the fund long enough to ensure the manager's ability to implement the intended fund strategy, then begin to see the results of that strategy. There is no standard lock-up period, which can differ from fund to fund, and it should always be noted that during the lock-up period, the investment is essentially rendered illiquid.
There are many different types of asset-backed securities, but the common theme uniting all of them is A) they are usually backed by a single source of payment. B) they are supported by a contractual obligation to pay. C) they are a form of equity financing. D) they tend to be exchange traded.
B) they are supported by a contractual obligation to pay. Asset-backed securities (ABS) are structured debt financing backed by a contractual agreement to pay. They are "first cousins" to MBS (mortgage-backed securities), with the primary difference being that the collateral is not real estate. These securities trade in the OTC market. One of the benefits of the structured package is that the investor is not relying on payments from a single borrower; rather, there is a pool of loans, whether they be auto, credit card, or others.
Which of the following accounts would a CMO Z-tranche be best suited for? A) A custodial account set up under the Uniform Transfer to Minors Act (UTMA) B) An IRA account for a middle-aged client who is willing to defer the income C) A joint account where the owners are looking to diversify and lower their risk D) A professionally managed hedge fund specializing in real estate portfolio securities
D) A professionally managed hedge fund specializing in real estate portfolio securities A zero tranche (Z-tranche) CMO is considered to be among the most volatile CMO tranches because no payments are received until all preceding tranches of the CMO are retired. Generally, CMO tranches are not suitable for smaller or unsophisticated investors, which is why customers are required to sign a suitability statement before purchasing any CMO tranche. Of the answer choices given, the best suited account would be the one that is professionally managed and already specializing in real estate investments.
Hedge funds are highly regulated. use investment techniques suitable for most investors. are unregulated. use investment techniques most suitable for sophisticated investors. A) I and II B) II and III C) I and IV D) III and IV
D) III and IV Hedge funds are unregulated and have aggressively managed portfolios that employ investment techniques such as shorting positions, utilizing derivative products, and trading on margin—all generally considered suitable for sophisticated investors.
Which of the following assets would be least likely used to back a collateralized debt obligation (CDO)? A) Auto loans B) Credit card debt C) Corporate receivables D) Mortgages
D) Mortgages Unlike CMOs, which are backed by mortgages (as the M indicates), CDOs are invariably backed by some other form of asset. Remember that what someone owes is their debt, while it is an asset to the creditor.
