CFA Program — Alternative Investments

Question 1

A hedge fund pursuing a global macro strategy primarily aims to profit from:

• A) Company-specific merger events only
• B) Broad macroeconomic trends and top-down views across countries, interest rates, currencies, and other asset classes
• C) A single stock's idiosyncratic earnings surprises
• D) Fixed, contractually guaranteed returns

Question 2

In private equity, the "J-curve" effect refers to the pattern in which fund returns typically:

• A) Are highest in the first year and decline steadily thereafter
• B) Are initially negative in early years (due to fees and unrealized investments) before turning positive as investments mature and are exited
• C) Remain constant throughout the fund's life
• D) Are always negative for the entire fund life

Question 3

Which valuation approach is most commonly used to value real estate income-producing property based on its expected future net operating income?

• A) The cost approach
• B) The sales comparison approach
• C) The income approach (e.g., direct capitalization or discounted cash flow)
• D) The liquidation approach

Question 4

Hedge fund performance is sometimes criticized for "survivorship bias" in reported index returns. This bias arises because:

• A) Only funds that continue reporting (often better performers, since failed funds stop reporting) are included in historical index calculations, overstating average historical returns
• B) All funds, regardless of performance, are always included equally
• C) Survivorship bias only affects mutual funds, not hedge funds
• D) It refers to the risk of an individual investor outliving their investment horizon

Question 5

A merger arbitrage (risk arbitrage) hedge fund strategy typically involves:

• A) Buying shares of the target company and, in a stock deal, shorting shares of the acquiring company, profiting from the spread narrowing as the deal closes
• B) Only investing in companies with no pending corporate actions
• C) Shorting the target company exclusively
• D) Investing solely in government bonds

Question 6

Which of the following best describes "dry powder" in the context of private equity funds?

• A) Capital that has been committed by investors but not yet called (invested) by the fund
• B) Cash that has already been fully distributed to limited partners
• C) A fund's total realized losses
• D) The management fee charged annually by the fund

Question 7

Which of the following best describes a "clawback" provision in a private equity fund's limited partnership agreement?

• A) A provision that eliminates the general partner's performance fee entirely from inception.
• B) A provision requiring the general partner to return excess performance (carried interest) fees to limited partners if later, poorer-performing investments mean the GP received more in fees over the fund's life than the agreed profit-sharing formula ultimately allows.
• C) A provision that guarantees the general partner keeps all performance fees regardless of subsequent fund performance.
• D) A provision requiring limited partners to return all invested capital immediately upon request.

Question 8

Which of the following best describes a "fixed-income arbitrage" hedge fund strategy?

• A) Investing exclusively in a single long-only government bond portfolio with no hedging.
• B) A strategy focused entirely on real estate investments.
• C) A strategy that avoids the use of any leverage under all circumstances.
• D) Exploiting perceived pricing discrepancies among related fixed-income securities, often using leverage, while attempting to hedge out much of the broad interest rate risk.

Question 9

Which of the following best describes a key challenge in accurately measuring the risk (volatility) of hedge fund returns using standard deviation of reported monthly returns?

• A) Return smoothing from infrequently priced or illiquid holdings can understate the fund's true economic volatility, since manager-estimated valuations may not immediately reflect market-driven price changes.
• B) Hedge funds always report returns with complete daily market pricing for every position.
• C) Standard deviation is always a perfectly accurate risk measure for any hedge fund strategy.
• D) Hedge fund returns cannot be measured using standard deviation under any circumstances.

Question 10

Which of the following best describes the "J-curve effect" typically observed in private equity fund performance over its life?

• A) A guarantee that the fund will underperform public markets throughout its life.
• B) Reported returns are often negative in the early years due to fees and unrealized investments carried conservatively, then turn positive as portfolio companies mature and are exited.
• C) Reported returns are always positive from the very first year of the fund.
• D) A pattern that applies only to hedge funds, never to private equity funds.

Question 11

An analyst evaluating a private equity fund's performance uses the "public market equivalent" (PME) method. This method is primarily intended to:

• A) Eliminate the need to consider any cash flow timing in performance measurement.
• B) Apply exclusively to hedge funds, never to private equity.
• C) Compare the private equity fund's returns against what would have been earned by investing the same cash flows in a public market benchmark index over the same period.
• D) Guarantee the private equity fund outperforms all public market indices.

Question 12

An institutional investor is evaluating an allocation to private debt (direct lending) as an alternative to traditional public high-yield bonds. Which of the following is a commonly cited potential benefit of private debt?

• A) Complete elimination of credit risk relative to public bonds.
• B) No difference whatsoever compared to investing in public high-yield bonds.
• C) Potentially higher yields and stronger negotiated covenant protections, in exchange for accepting significantly reduced liquidity compared to public bonds.
• D) Guaranteed daily liquidity identical to publicly traded bonds.

Question 13

Which of the following best describes "dispersion trading," a strategy sometimes employed by volatility-focused hedge funds?

• A) A strategy with no relationship to volatility or correlation.
• B) A strategy that can only be implemented using physical stock purchases, never derivatives.
• C) Taking a position based on a view about the relationship between an index's implied volatility and the implied volatilities of its individual constituent stocks, often involving selling index volatility and buying volatility on the individual components (or vice versa).
• D) A strategy focused exclusively on physical commodity delivery.

Question 14

Which of the following best describes the concept of "vintage year diversification" in private equity portfolio construction?

• A) A concept that applies only to hedge funds, never to private equity.
• B) A guarantee that all vintage years will produce identical returns.
• C) Committing capital to private equity funds across multiple different vintage years (start years) rather than concentrating commitments in a single year, reducing exposure to the risk that any single year's market entry conditions prove unfavorable.
• D) Investing only in funds from a single vintage year to maximize concentration.

Question 15

Which of the following best describes "special situations" investing as a hedge fund or private equity strategy category?

• A) Investing exclusively in government treasury securities with no corporate event focus.
• B) A strategy that avoids any consideration of specific corporate events.
• C) A strategy applicable only to real estate investments.
• D) Investing based on specific corporate events, such as spin-offs, restructurings, or other significant corporate actions, that create temporary pricing dislocations or unique opportunities distinct from a company's ordinary-course fundamentals.

Question 16

Which of the following best describes a key operational due diligence consideration when evaluating a hedge fund investment, distinct from evaluating the manager's investment strategy itself?

• A) Assessing the fund's administrative infrastructure, including the independence and quality of its fund administrator, auditor, and internal controls, to help identify risks of fraud or operational failure separate from investment strategy risk.
• B) Operational due diligence is identical to evaluating the manager's investment track record.
• C) Operational due diligence has no relevance to hedge fund investment decisions.
• D) Operational due diligence applies only to publicly traded mutual funds, never hedge funds.

Question 17

Which of the following best describes the role of a private equity fund's "general partner clawback" provision in aligning incentives between the GP and LPs?

• A) It applies only to hedge funds, never to private equity funds.
• B) It helps ensure that, over the full life of the fund, the general partner's total carried interest does not exceed what the agreed profit-sharing formula ultimately allows, protecting limited partners from overpayment based on early strong performance that is not sustained.
• C) It guarantees the general partner will always receive the maximum possible carried interest regardless of fund performance.
• D) It has no relationship to aligning GP and LP incentives.

Question 18

Which of the following best describes a "quantitative equity market neutral" hedge fund strategy?

• A) Investing exclusively in a single long-only equity index fund with no hedging.
• B) A strategy that relies entirely on qualitative, discretionary judgment with no quantitative models.
• C) A strategy focused exclusively on government bonds with no equity exposure.
• D) Using systematic, model-driven stock selection to build simultaneous long and short equity positions constructed to have minimal net exposure to the overall market, aiming to profit from relative security selection rather than market direction.

Question 19

A venture capital firm invests in a seed-stage biotechnology startup. The most significant valuation challenge is:

• A) Selecting the appropriate discount rate for the DCF model
• B) Estimating revenues and cash flows for a pre-revenue company with uncertain outcomes
• C) Identifying comparable public biotechnology companies for relative valuation
• D) Determining the terminal growth rate for the Gordon Growth Model

Question 20

A commodity futures investor establishes a position by going long December wheat futures. Before expiration, she rolls into March futures by closing the December position and opening a March position. This roll will generate a positive return (roll return) when the market is in:

• A) Contango
• B) Normal backwardation
• C) Equilibrium (flat curve)
• D) Inverted yield curve

Question 21

A direct real estate investor wants to estimate the going-in cap rate for a property. NOI next year is expected to be $1.2M and the expected growth rate is 3%. If the required return is 8%, the going-in cap rate is:

• A) 3.0%
• B) 5.0%
• C) 8.0%
• D) 11.0%

Question 22

Distressed debt investing in private equity involves:

• A) Buying the equity of financially healthy companies at a discount
• B) Acquiring the debt of companies in or near bankruptcy to profit from restructuring
• C) Short selling equity of overleveraged companies
• D) Lending to private companies that cannot access public markets

Question 23

In a hedge fund's fee structure, a high-water mark provision:

• A) Requires the fund to achieve returns above the risk-free rate before performance fees apply
• B) Prevents the fund manager from earning incentive fees on gains that simply recover previous losses
• C) Limits the maximum fee that can be charged in any single year
• D) Applies only to long-short equity strategies

Question 24

A private real estate investment is valued using the income approach. Net operating income is $800,000 and comparable properties have cap rates of 6%. The estimated property value is:

• A) $4,800,000
• B) $13,333,333
• C) $800,000
• D) $8,000,000

Question 25

An "equity market neutral" hedge fund strategy is generally designed to:

• A) Invest exclusively in a single stock with no offsetting positions.
• B) Guarantee positive returns regardless of the manager's stock-picking skill.
• C) Construct offsetting long and short equity positions such that the portfolio's net exposure to overall market movements (beta) is approximately zero, seeking to profit from relative security selection rather than market direction.
• D) Maintain a large net long exposure to the overall stock market at all times.

Question 26

A private equity fund's "J-curve" effect refers to the typical pattern in which:

• A) Fund returns are always positive from the very first year of the fund's life.
• B) The fund's returns follow a perfectly straight line over its entire life.
• C) The J-curve applies exclusively to publicly traded equity funds, never to private equity.
• D) Reported fund returns are initially negative in the early years, due to fees and unrealized investment costs, before turning positive as portfolio companies mature and are exited.

Question 27

A hedge fund's "high-water mark" provision means that the manager:

• A) Is prohibited from ever charging any fees to investors.
• B) Must return all prior fees if the fund experiences a single down year.
• C) Only earns a performance fee on new gains that exceed the fund's previous highest net asset value, preventing the manager from earning fees again on recovering losses.
• D) Automatically earns a performance fee every year regardless of performance.

Question 28

An investor evaluating hedge fund performance data should be aware of "survivorship bias" in hedge fund databases, which arises because:

• A) Survivorship bias only affects mutual funds, never hedge funds.
• B) Funds that perform poorly and close often stop reporting or are removed from databases, causing historical performance averages calculated from currently listed funds to be biased upward.
• C) All hedge funds, regardless of performance, are always included in every database indefinitely.
• D) Survivorship bias causes reported historical returns to be biased downward.

Question 29

Which of the following best describes an infrastructure investment, as a subcategory of real assets?

• A) An investment in long-lived, capital-intensive physical assets (such as toll roads, airports, or utilities) that often provide relatively stable, inflation-linked cash flows.
• B) A short-term, highly liquid money market instrument.
• C) An investment exclusively in early-stage technology startups.
• D) An investment with no relationship to physical assets of any kind.

Question 30

A distressed debt hedge fund strategy typically involves:

• A) Investing exclusively in the highest-rated government bonds.
• B) Avoiding any companies experiencing financial difficulty.
• C) Guaranteeing full repayment of principal regardless of the company's outcome.
• D) Purchasing the debt of financially troubled companies at a discount, seeking to profit from a successful restructuring, recovery, or favorable resolution of the distress.

Question 31

An appraiser values an income-producing commercial office property using the direct capitalization approach. The property's stabilized annual net operating income (NOI) is $850,000, and comparable properties in the market are trading at capitalization rates of 6.5%. Using direct capitalization, the estimated property value is closest to:

• A) $5,525,000, which incorrectly multiplies NOI by the capitalization rate ($850,000 x 0.065) rather than dividing NOI by the capitalization rate.
• B) $13,076,923, calculated as Value = NOI / Capitalization rate = $850,000 / 0.065 = $13,076,923.
• C) $850,000, which incorrectly reports the annual NOI figure itself as the property's estimated value, ignoring the capitalization rate entirely.
• D) $1,307,692, which is off by a factor of ten from the correct calculation, likely due to a decimal placement error in dividing NOI by the capitalization rate.

Question 32

A private equity fund's net cash flows to limited partners typically follow a distinctive pattern over the fund's life, characterized by net cash outflows (capital calls exceeding distributions) in the early years, followed by net cash inflows (distributions exceeding remaining calls) in later years as portfolio companies are exited. This pattern, when plotted cumulatively over the fund's life, is best described as:

• A) The efficient frontier, a concept from modern portfolio theory describing optimal risk-return combinations across asset allocations, not the cash flow timing pattern of an individual private equity fund's life cycle.
• B) The yield curve, a concept describing the relationship between bond yields and maturities across a fixed-income market, unrelated to a private equity fund's cash flow pattern over its life.
• C) The J-curve effect, reflecting cumulative fund returns that initially decline (as management fees and early investment costs are incurred before portfolio companies mature and are realized) before eventually rising as successful investments are exited and distributions are made to limited partners.
• D) Contango, a term describing a specific futures curve shape in commodity markets, unrelated to the private equity fund cash flow pattern being described.

Question 33

An appraiser valuing an income-producing property considers both the income approach (direct capitalization or discounted cash flow) and the sales comparison approach (using recent comparable property transactions). In a market where few truly comparable recent transactions exist but the subject property has stable, well-documented rental income and expenses, which approach is generally most appropriate to weight more heavily, and why?

• A) The sales comparison approach should always be weighted exclusively, regardless of the availability or quality of comparable transaction data, since it is assumed to always be inherently more reliable than the income approach under any circumstances.
• B) The income approach should generally be weighted more heavily, since it relies on the property's own well-documented income and expense characteristics rather than requiring a sufficient number of genuinely comparable recent transactions, which are scarce in this scenario and could otherwise introduce significant appraisal uncertainty.
• C) Neither approach is appropriate in this scenario; the cost approach (replacement cost less depreciation) must always be used exclusively whenever comparable sales data is limited.
• D) Both approaches should be weighted exactly equally by convention regardless of the relative quality, quantity, or reliability of the available comparable transaction data or the property's income data.

Question 34

A commodity futures curve is currently in backwardation, with the near-month (expiring) futures contract priced at $68.00 per barrel and the next (further-dated) futures contract priced at $66.50 per barrel. An investor holding a long position in the near-month contract rolls the position forward by selling the expiring contract and buying the next contract just before expiration. The approximate roll return (roll yield) from this transaction is closest to:

• A) +2.21%, calculated as Roll return = (Near-month price - Far-month price) / Near-month price = ($68.00 - $66.50) / $68.00 = $1.50 / $68.00 = 2.21%, a positive roll yield characteristic of markets in backwardation, where the investor sells the higher-priced expiring contract and buys the lower-priced further-dated contract.
• B) -2.21%, which incorrectly reverses the sign of the roll return; backwardation (near-month price above far-month price) produces a positive, not negative, roll return for a long investor rolling the position forward.
• C) +2.26%, which incorrectly divides the price difference by the far-month price ($66.50) rather than by the near-month price ($68.00), which is the standard convention for calculating roll return.
• D) 0%, which incorrectly assumes no roll return exists because the difference between contract prices is not multiplied out, ignoring the actual price differential between the near-month and far-month contracts.

Question 35

A private equity fund raises $50 million in committed capital from limited partners (LPs). The fund's distribution waterfall specifies: (1) return of the $50 million capital to LPs; (2) an 8% preferred return to LPs, equal to $4 million; (3) a 100% GP catch-up until the general partner (GP) has received 20% of all profit distributed above return of capital; and (4) an 80/20 LP/GP split of all remaining proceeds. If the fund's total exit proceeds are $90 million, the GP's total carried interest is closest to:

• A) $4.0 million, which incorrectly reflects only the LP's preferred return figure and fails to calculate the GP's catch-up and subsequent 80/20 profit share.
• B) $18.0 million, which incorrectly applies a 20% carried interest rate to the full $90 million in exit proceeds rather than to the $40 million in profit above the LPs' original capital contribution.
• C) $7.0 million, which correctly calculates the GP's share of the final 80/20 split but incorrectly omits the additional $1.0 million GP catch-up amount from the total carried interest figure.
• D) $8.0 million: GP catch-up = $4M x (0.20/0.80) = $1.0M, bringing distributions after return of capital to $4M (preferred) + $1M (catch-up) = $5M, all attributable to the GP's 20% target at this stage. Remaining proceeds = $90M - $50M - $4M - $1M = $35M, split 80/20: LP receives $28M, GP receives $7M. Total GP carried interest = $1.0M (catch-up) + $7.0M (80/20 split) = $8.0 million, which equals exactly 20% of the fund's total profit above return of capital ($90M - $50M = $40M).

Question 36

An investor allocates $100 million to a hedge fund at the start of the year, which also serves as the fund's initial high-water mark. The fund charges a 2% annual management fee (on beginning-of-year net asset value) and a 20% incentive fee on gains in excess of the high-water mark, with the incentive fee calculated after deducting the management fee. The fund's gross return for the year (before any fees) is 15%. The investor's net return for the year, after both fees, is closest to:

• A) 15.00%, which incorrectly reports the fund's gross (pre-fee) return, ignoring both the management fee and the incentive fee entirely.
• B) 12.00%, which incorrectly deducts only the 2% management fee and a flat 1% (rather than 20% of the actual post-management-fee profit) as the incentive fee.
• C) 10.40%: Gross ending value = $100M x 1.15 = $115M. Management fee = 2% x $100M = $2M, leaving $113M. Profit above the $100M high-water mark after the management fee = $113M - $100M = $13M. Incentive fee = 20% x $13M = $2.6M. Net ending value = $113M - $2.6M = $110.4M. Net return = ($110.4M - $100M)/$100M = 10.40%.
• D) 8.40%, which incorrectly calculates the incentive fee as 20% of the full $15M gross gain rather than 20% of the $13M profit remaining after the management fee is deducted.