CFA Level 1 - Alternative Investments Session 13 - Reading 47

CFA Level 1 - Alternative Investments Session 13 - Reading 47 (Notes, Practice Questions, Sample Questions) 1. Compared to a mutual fund, a hedge fund is most likely to have lower levels of: A)disclosure. B)usage of derivatives.C)leverage. {Explanation}: Hedge funds are relatively unregulated, and have minimal disclosure requirements. Unlike mutual funds, hedge funds arenot subject to limits on the use of leverage and derivatives 2. Compared to a mutual fund, a hedge fund is most likely to have lower: A)disclosure requirements. B)lockup periods.C)fees. {Explanation}: Due to the unregulated nature of hedge funds, hedge funds are required to provide only minimal disclosure to investors (andeven less disclosure to non-investors). Hedge funds often have a one,

two, or three year lockup periods, while mutual funds generally havedaily liquidity. Hedge fund fees are generally higher than mutual fundfees, because on top of a management fee (typically 2%), hedge fundsalso charge a performance fee (typically 20% of profits.) 3. Alpha hedge fund limits withdrawals by investors during the first three years by imposing a redemption fee of 3%. Such provisions by hedgefunds are called: A)hard lockup.B)regulatory disclosure. C)soft lockup. {Explanation}: Lockups which allow for redemption on payment of penalty are called as soft lockup. Under hard lockup, withdrawals arenot permitted. 4. A hedge fund with a fixed-income arbitrage strategy is most likely to suffer a loss when: A)credit spreads widen quickly. B)leverage becomes less expensive.C)markets for lower quality debt become more liquid {Explanation}: Fixed-income arbitrage generally involves buying high-yielding (low quality) bonds while selling low-yielding (highquality) bonds. Leverage can be used in place of selling high quality

bonds. This strategy can suffer great losses when credit spreads widenquickly, when leverage becomes more expensive, or when the marketsfor low-quality debt become less liquid 5. A “risk arbitrage” (or “merger arbitrage”) strategy: A)is considered a “long volatility” strategy. B)experiences losses when a planned merger is cancelled. C)involves purchasing the stock of an acquiring company {Explanation}: A merger arbitrage strategy is considered a “short volatility” strategy: this strategy will experience a loss if the expectedmerger is cancelled. This strategy involves purchasing the stock of thetarget company and shorting the stock of the acquiring company 6. Which of the following is most accurate in describing the problems of survivorship bias and backfill bias in the performance evaluation ofhedge funds? A)Survivorship bias and backfill bias both result in downwardly biasedhedge fund index returns. B)Survivorship bias and backfill bias both result in upwardly biasedhedge fund index returns. C)Survivorship bias results in upwardly biased hedge fund index returns,but backfill bias results in downwardly biased hedge fund index returns {Explanation}: The problem in survivorship bias is that only the returns for survivors will be reported and the index return will be biased

upwards. Backfill bias results when a new hedge fund is added to anindex and the fund's historical performance is added to the index'shistorical performance. The problem is that only funds that survivedwill have their performance added to the index, resulting in an upwardbias in index returns 7. A hedge fund investor is most likely to express a preference for returns distribution that has: A)a negative skew. B)low kurtosis. C)high variance {Explanation}: Investors prefer a return distribution with low kurtosis, low variance, a high mean and positive skewness 8. Adding long volatility hedge fund strategies to a portfolio of short volatility hedge fund strategies is most likely to increase theattractiveness of the portfolio return’s: A)Sharpe ratio. B)skewness and kurtosis exposures. C)reported volatility {Explanation}: Adding long volatility strategies to a portfolio of short volatility strategies would increase the volatility of portfolio returnsand decrease the portfolio’s Sharpe ratio. However, the resulting

portfolio returns distribution will be more normally distributed andskewness and kurtosis characteristics of the return distribution will bemore attractive to investors 9. Studies using factor models have generally found the largest contributor to hedge fund returns to be: A)traditional market factor exposures. B)manager skill.C)exotic beta exposures {Explanation}: Studies have found that the majority of hedge fund styles can be relatively closely replicated using traditional marketexposures such as stock and bond indices, currency, and commoditymarket returns. These traditional market risk factors have been foundto explain 50%–80% of hedge fund returns 10. A misspecification of a hedge fund factor model that omits relevant risk factors is most likely to cause alpha to be: A)underestimated. B)overestimated. C)negative. {Explanation}: Hedge fund factor models generally attribute hedge fund return to the sum of alpha, the risk-free rate, and the sum of theimpacts of the relevant risk factors. If some of the relevant risk factors

are omitted from the model, the alpha (return due to manager skill) islikely to be over-estimated 11. Which of the following most accurately describes the distribution of hedge fund returns? Hedge fund returns: A)are lognormally distributed. B)have fat tails in the distribution. C)are normally distributed {Explanation}: Investors should be concerned about hedge fund risk because hedge fund returns have fat tails on the left hand side of theirdistribution. In other words, the probability of large losses is greaterthan that expected from a normal distribution. For this reason, it isimperative that investors evaluate a downside measure of risk, such asmaximum drawdown and/or value at risk 12. The return distribution of a merger arbitrage strategy, in which the fund manager purchases the target company and shorts the acquiringcompany stock, is best described as: A)normally distributed.B)positively skewed. C)highly kurtotic.

{Explanation}: The returns of many hedge fund strategies – including merger arbitrage trades – are not normally distributed; rather they arehighly kurtotic and negatively skewed. 13. Non-normality in hedge fund returns is most likely to cause performance to be: A)underestimated.B)zero. C)overestimated {Explanation}: Non-normality of hedge fund returns necessitates consideration of higher order moments of the returndistribution—specifically skewness and kurtosis. For most hedge funds,the return distribution is negatively skewed and highly kurtocic. Theseare undesirable qualities from the perspective of an investor. Ignoringthese higher-order moments leads to overestimation of performance 14. An investor considering investing in a hedge fund, would be most likely motivated in pursuing replicating strategy, rather than investing inthe hedge fund directly when the hedge fund: A)has a long lockup period. B)returns have a large alpha component.C)strategies are clearly disclosed.

{Explanation}: Investors may be motivated to choose hedge fund replication strategies over actual investments in hedge funds when: (1)hedge fund managers are not earning a positive alpha, (2) investorsfeel that the fees paid to hedge fund managers are not justified, and (3)investors have objections to hedge funds’ lack of transparency orliquidity 15. A difficulty in applying traditional portfolio analysis to hedge funds is that hedge funds have: A)high standard deviation.B)correlations with other asset classes that are static. C)non-normal return distribution {Explanation}: Traditional portfolio analysis calculates the most efficient portfolio using return, correlation and volatility of assets.However, it is difficult to apply traditional portfolio analysis to hedgefunds because: (1) it is difficult to develop accurate expected returns, (2)hedge fund correlation, beta exposures, and volatility can change overtime, and (3) standard deviation is not a complete measure of hedgefund risk due to higher moment risks such as skewness and kurtosis.This is due to non-normal distribution of hedge fund returns 16. The usual result of adding hedge funds to a portfolio of traditional (stocks and bonds) investments is a decrease in: A)standard deviation.

B)Sharpe ratio.C)skewness and kurtosis {Explanation}: The usual result of adding hedge funds to a portfolio of traditional investments is that: (1) standard deviation will decrease, (2)the Sharpe ratio will increase, and (3) higher-moment exposures suchas skewness and kurtosis will increase 17. Compared to a single manager hedge fund, a fund of funds is most likely to have higher: A)management and performance fees. B)return performance.C)standard deviation {Explanation}: Funds of funds generally have higher management and performance fees than single manager hedge funds because funds offunds generally apply a second layer of fees on top of those paid to theunderlying fund managers. Fund of funds’ returns tend to be equal toaverage hedge fund index performance—before fund of funds’ secondlayer of fees are deducted. By investing in 15 or more single managerfunds of various strategies (diversifying), funds of funds achieve lowerstandard deviation

18. Compared to a single manager hedge fund, a fund of funds is most likely to have higher: A)longevity. B)survivorship bias.C)backfill bias. {Explanation}: Funds of funds generally have lower mortality, lower survivorship bias, and lower backfill bias than single manager hedgefunds