CFA Program — Alternative Investments

Correct answer: B) A fund that invests in a portfolio of other alternative investment funds, providing diversification but adding a layer of fees

A fund-of-funds invests in a portfolio of underlying alternative investment funds (e.g., multiple hedge funds or private equity funds), offering diversification and manager selection expertise, but typically adds an additional layer of fees on top of the underlying funds' fees.

Correct answer: B) Hedge funds often use leverage and derivatives and charge performance-based fees

Hedge funds typically have more flexible investment mandates than mutual funds, often employing leverage, derivatives, and short selling, and commonly charge both a management fee and a performance fee (e.g., "2 and 20").

Correct answer: B) Leveraged buyouts (LBOs)

Leveraged buyouts involve acquiring a company using a significant amount of borrowed money, typically targeting mature companies with stable cash flows that can service the acquisition debt, in contrast to venture capital, which typically funds early-stage companies.

Correct answer: B) Relatively low liquidity and high transaction costs compared to publicly traded securities

Real estate is generally characterized by lower liquidity, higher transaction costs, and longer holding periods compared to publicly traded securities, along with sensitivity to local economic and demographic conditions.

Correct answer: B) Can provide diversification benefits due to relatively low correlation with traditional stocks and bonds, and may hedge against inflation

Commodities often exhibit relatively low correlation with traditional stock and bond returns, and can serve as a hedge against inflation, both of which support their inclusion in a diversified portfolio.

Correct answer: B) Early-stage, high-growth-potential private companies

Venture capital provides equity financing to early-stage companies with high growth potential, typically in exchange for an ownership stake, accepting higher risk in pursuit of potentially outsized returns.

Correct answer: D) A publicly traded partnership that combines the tax benefits of a partnership structure (pass-through taxation) with the liquidity of a publicly traded security.

An MLP is a publicly traded limited partnership, common in energy infrastructure (like pipelines), that combines pass-through taxation (avoiding corporate-level tax) with the liquidity benefits of trading on a public exchange, unlike a typical private partnership.

Correct answer: C) Taking positions across multiple asset classes and countries based on broad macroeconomic views, such as interest rate, currency, or economic growth trends.

Global macro strategies take positions across a wide range of asset classes (equities, bonds, currencies, commodities) and countries, based on the manager's broad macroeconomic views about interest rates, growth, inflation, or policy trends.

Correct answer: B) A 2% annual management fee and a 20% performance (incentive) fee on profits.

The common "2 and 20" fee structure in hedge funds and private equity refers to a 2% annual management fee on assets under management, plus a 20% performance (incentive) fee on profits generated, often subject to a hurdle rate or high-water mark.

Correct answer: A) The GP manages the fund's investments and operations, and typically bears unlimited liability, while limited partners (investors) provide the majority of the capital with limited liability.

In a typical private equity fund structure, the general partner manages the fund's investments and day-to-day operations and bears unlimited liability, while limited partners (the investors) contribute most of the capital and have limited liability, with no direct role in day-to-day management.

Correct answer: D) Greater potential for direct control over the property but with significantly lower liquidity and higher transaction costs.

Direct real estate ownership can offer greater control over property decisions (management, renovations, financing) compared to REIT shares, but it typically comes with significantly lower liquidity, higher transaction costs, and more concentrated, undiversified risk than a publicly traded REIT.

Correct answer: C) Taking a significant equity stake in a company and actively pushing for specific changes in strategy, management, or capital allocation to increase shareholder value.

Activist hedge fund strategies involve acquiring a meaningful equity stake in a target company and then actively engaging with (or publicly pressuring) management and the board to pursue specific changes -- such as strategic shifts, cost cuts, or capital return policies -- intended to unlock shareholder value.

Correct answer: C) The year in which a private equity fund makes its first investment or draws down capital, used to compare fund performance against peers from the same starting period.

Vintage year refers to the year a private equity fund begins investing (its first capital call/investment), and it is commonly used to benchmark a fund's performance against other funds from the same vintage year, since market conditions at the time of initial investment can significantly affect outcomes.

Correct answer: D) The acquisition of a company using a significant amount of borrowed money, with the target company's own assets and cash flows often used as collateral for the debt.

A leveraged buyout involves acquiring a company using a substantial amount of borrowed funds, with the target company's assets and future cash flows frequently pledged as collateral and used to service the acquisition debt, a hallmark strategy of many private equity firms.

Correct answer: C) The fund may hold illiquid or infrequently priced positions, whose valuations can create a "smoothing" effect that understates the fund's true volatility.

Illiquid or infrequently priced (or manager-marked) positions can create a "return smoothing" effect in reported performance, understating the fund's true economic volatility and potentially overstating risk-adjusted performance measures like the Sharpe ratio, a known consideration when evaluating hedge funds with less liquid holdings.

Correct answer: D) Committed capital is the total amount investors have pledged to the fund, while called capital is the portion actually drawn down and invested by the fund manager as needed over time.

Committed capital represents the total amount limited partners have pledged to a private equity fund over its life, while called capital is the portion the general partner has actually drawn down (called) from investors to fund specific investments, typically over several years rather than all at once.

Correct answer: A) Simultaneously holding a long position in a convertible bond and a short position in the underlying stock, seeking to profit from pricing inefficiencies between the two related securities.

Convertible arbitrage involves purchasing a company's convertible bond while simultaneously shorting the underlying common stock, aiming to profit from perceived mispricing between the convertible security and the stock, while attempting to hedge out much of the directional equity risk.

Correct answer: B) Long useful life, high barriers to entry, and often stable, sometimes regulated or contracted cash flows.

Infrastructure assets like toll roads, airports, and utilities typically feature long useful lives, significant barriers to entry (due to high capital costs and often regulatory or geographic constraints), and relatively stable cash flows, sometimes governed by long-term contracts or regulation.

Correct answer: C) 90%

US REITs must distribute at least 90% of taxable income to shareholders to qualify for REIT status and avoid corporate-level taxation. Most REITs distribute more than 90%.

Correct answer: C) $80,000

Management fee = 2% × $1,000,000 = $20,000. Performance fee = 20% × $300,000 gain = $60,000. Total = $80,000. Note: management fee is typically on beginning AUM; performance fee on profits above hurdle (assumed none here).

Correct answer: B) Lower liquidity and higher return potential (illiquidity premium)

Private equity investments are illiquid (lock-up periods of 5-10 years are common). Investors expect to be compensated with higher returns — the illiquidity premium — compared to comparable public investments.

Correct answer: B) Early negative cash flows followed by positive returns as investments mature

In the early years of a PE fund, capital is called for investments and fees while distributions are minimal, resulting in negative net cash flows. As portfolio companies are sold, distributions exceed contributions — a J-shaped cumulative cash flow profile.

Correct answer: B) High correlation with public equities in the short term

Timberland historically has low correlation with public equities, which is a key diversification benefit. Biological growth, inflation hedging, and harvest timing flexibility are genuine features of timberland investment.

Correct answer: B) Futures prices are below spot prices

Backwardation exists when futures prices are below the current spot price. This often occurs when there is a high convenience yield (scarcity of the physical commodity), making the spot price high relative to futures.

Correct answer: A) Potential diversification benefits and different return drivers, but typically with less liquidity and less transparency.

Alternative investments often provide diversification benefits due to lower correlation with traditional asset classes, but they typically come with tradeoffs including reduced liquidity (often subject to lock-up periods), less transparency, and higher fees compared to traditional public market investments.

Correct answer: D) A fund that invests in a portfolio of other hedge funds, rather than directly in individual securities.

A fund of funds pools investor capital to invest across multiple underlying hedge funds, offering diversification across strategies and managers, typically in exchange for an additional layer of fees on top of the underlying funds' fees.

Correct answer: C) Longer investment holding periods and significantly reduced liquidity for investors.

Private equity investments are generally illiquid, with capital typically locked up for several years (often five to ten years or more) as the fund executes its investment strategy, in contrast to publicly traded equities, which can be bought and sold daily on an exchange.

Correct answer: B) Greater liquidity, since many REITs are publicly traded and can be bought and sold like stocks.

Publicly traded REITs offer investors exposure to real estate income and appreciation potential with much greater liquidity than direct property ownership, since REIT shares can typically be traded on public exchanges, unlike physical real estate.

Correct answer: A) Taking long positions in stocks expected to outperform and short positions in stocks expected to underperform, potentially reducing overall market exposure.

A long/short equity strategy involves simultaneously holding long positions in stocks the manager expects to outperform and short positions in stocks expected to underperform, which can reduce net market exposure while attempting to profit from the relative performance between the two groups.

Correct answer: D) A potential hedge against inflation and diversification benefits due to historically lower correlation with traditional stocks and bonds.

Commodities have historically shown relatively low correlation with traditional stock and bond returns and have often been viewed as a potential inflation hedge, since commodity prices frequently rise during inflationary periods, though commodities themselves can be highly volatile and offer no guaranteed returns.

Correct answer: B) A distressed debt (special situations) strategy

Distressed debt (or special situations) strategies involve investing in the securities of financially troubled companies, often at substantial discounts to par or fundamental value, seeking to profit from a successful reorganization, restructuring, or other favorable resolution of the company's financial distress.

Correct answer: C) Better align the manager's incentive fee with actual value created for investors, since the hurdle rate requires a minimum return threshold before any performance fee is earned, and the high-water mark prevents the manager from collecting a performance fee on gains that merely recover prior losses rather than represent genuinely new net profits.

A hurdle rate requires the fund to first achieve a minimum specified return before the manager can earn any incentive (performance) fee, while a high-water mark ensures the manager only earns performance fees on new net gains above the fund's previous peak value, preventing the manager from being paid twice for simply recovering earlier losses -- together, these provisions help better align manager compensation with genuine value creation for investors.

Correct answer: B) The investment offers a degree of "harvest timing" flexibility, since trees continue to grow (biological growth) even if the owner delays harvesting during periods of weak lumber prices, providing some flexibility not available with many other commodities.

A distinctive feature of timberland is that the underlying asset (trees) continues to grow biologically over time, adding value even without immediate harvest, which gives owners some flexibility to delay selling during periods of low lumber prices and instead let the trees keep growing until prices improve -- a form of optionality not typically available with many other commodity investments.

Correct answer: A) Initially negative or low reported returns in the fund's early years, driven by management fees and initial investment costs before portfolio companies have had time to mature and generate value, followed by improving and typically positive returns in later years as investments are realized.

The J-curve describes the typical pattern of private equity fund returns: early years often show negative or low reported returns due to management fees, transaction costs, and unrealized (often conservatively valued) investments, while later years typically show improving returns as portfolio companies mature and are successfully exited, causing the return profile, when plotted over time, to resemble the letter J.

Correct answer: D) Equity REITs directly own and typically operate income-producing physical real estate properties, generating revenue primarily from rental income, while mortgage REITs primarily hold mortgage loans and mortgage-backed securities, generating revenue primarily from interest income.

Equity REITs own and generally operate physical, income-producing real estate (such as office buildings, apartments, or shopping centers), earning revenue mainly from rents, while mortgage REITs primarily hold mortgage loans or mortgage-backed securities and earn revenue mainly from the interest income on those holdings, exposing them more directly to interest rate risk.

Correct answer: C) Simultaneously buying shares of the target company and selling short shares of the acquiring company (in the deal's exchange ratio), seeking to profit from the spread between the current target price and the implied deal value, while managing the risk that the deal fails to close.

In a stock-for-stock merger arbitrage strategy, the arbitrageur typically buys the target company's shares and sells short the acquirer's shares in proportion to the announced exchange ratio, aiming to capture the spread between the target's current price and its implied acquisition value, while bearing the risk that regulatory, financing, or shareholder issues cause the deal to fail (deal risk).