CFA Level 1 - Alternative Investments Session 18 - Reading 66 (Notes, Practice Questions, Sample Questions) 1. The per-share value of an investment company’s assets minus its liabilities is called the: A)discount. B)net asset value. C)current market value. Explanation — (B) The net asset value (NAV) of an investmentcompany is calculated as assets minus liabilities, stated on a per-sharebasis 2. For the equity shares of an open-end investment company, the share value: A)is determined in the secondary market. B)always equals NAV. C)may or may not equal NAV Explanation — (B) Shares of a closed-end investment company aredetermined in the secondary market and may or may not equal NAV.Share value of an open-end investment company always equals NAVbecause the investment company stands ready to redeem shares attheir net asset value 3. Both open-end and closed-end funds typically charge: A)an annual management fee.
B)a front-end load.C)a premium to the underlying net asset value (NAV) Explanation — (A) Both types of managed funds, open-end andclosed-end, typically charge an annual management fee. Open-endfunds sometimes charge a front-end load or a redemption fee, butclosed-end funds do not. Closed-end funds can sell at a premium (ordiscount) to underlying NAV, but this does not result in compensationto the fund 4. An investment company that stands ready to redeem investor shares at market value is classified as: A)an open-end investment company. B)a closed-end investment company.C)a managed investment company Explanation — (A) A closed-end investment company does not redeeminvestor shares; after issuance, shares trade in the secondary market.Some managed investment companies may redeem shares, but othersmay not. An open-end investment company always offers aredemption feature 5. The net asset value (NAV) of an open-end fund is determined by the: A)book value of all assets divided by the number of shares outstanding. B)market value of assets minus liabilities divided by the number ofshares outstanding. C)supply and demand for the shares in the investment managementcompany. Explanation — (B) This is the equation for the calculation of NAV
6. You are going to invest in a closed-end mutual fund and are told that the net asset value of the fund is $20.40, and the share price is $18.20. What isthe discount you would receive or the premium that you would pay? A)-0.1078. B)-0.1209.C)0.1209. Explanation — (A) (18.20 − 20.40)/20.40 = -0.1078 7. Which of the following statements about investment companies is least accurate? A)The investment company's board of directors hires an investmentmanagement company to select securities, manage the portfolio, andhandle administrative duties. B)Investment companies are generally wholly owned subsidiaries ofthe investment advisory firm that creates them. C)Generally the investment advisory firm initiating the fund will also act asthe fund's investment management company Explanation — (B) Investment companies are owned by individualinvestors. For example, individuals who purchase shares in a mutualfund are the "owners" of that fund 8. Jillian Best is choosing between two mutual funds. Fund A has a front-end load of 4%, a net asset value (NAV) of $60.00, and an expectedreturn of 13.0%. Fund B has a redemption fee of 1.5%, a NAV of $27, and anexpected return of 10%. Jillian will invest $50,000 in either fund. Which ofthe following statements is most accurate if Jillian has a 6-month holdingperiod? The: A)investor is better off with the front-end load fund by $120.00. B)investor is better off with the redemption fee fund by $592.50. C)investor is better off with the redemption fee fund by $712.50
Explanation — (B) Front end load fund: $50,000 (1 – 0.04)(1.065) =$51,120.00Redemption fee fund: $50,000 (1.05)(1 – 0.015) = $51,712.50Redemption fee fund advantage $592.50 9. The net asset value of a closed-end mutual fund is $11.20, and the share price is $10.00. The discount or premium is closest to: A)10.7% discount. B)12.0% premium.C)12.0% discount. Explanation — (A) (SP - NAV) / NAV = (10.00 - 11.20) / 11.20 = − 0.107 10. Bill Lynch, CFA, is a branch manager for a brokerage firm. He is reviewing a set of slides for a sales presentation that one of hissubordinates will deliver next week. In a section that explains the nature ofthe various fees charged by investment companies, Lynch finds slides thatstate the following:Slide 8: Fees charged by investment companies are a trade-off from theinvestor’s point of view. Lower fees will subtract less from the investor’srate of return, but higher fees give portfolio managers greater incentives toachieve higher returns.Slide 12: When choosing between a fund’s share classes, the investorshould select the class with the lowest total annual fees.Should Lynch agree or disagree with the statements on these two slides? Slide 8 Slide 12 A)Agree Disagree B)Disagree Disagree C)Disagree Agree
Explanation — (B) Lynch should disagree with both of thesestatements. Premiums, loads, and redemption fees are compensationfor sales and marketing efforts, but they are not performanceincentives for the portfolio managers. Different classes of shares canbe structured with different schedules of front-end, back-end, anddistribution fees. The optimal choice depends on the investor’sexpected holding period and is not necessarily the one with the lowesttotal annual fees 11. A sales commission charged by an investment company at the time of redemption is called a: A)12b-1 fee. B)back-end load. C)front-end load Explanation — (B) A front-end load is a sales commission charged atpurchase. A distribution fee, also called a 12b-1 fee, is an ongoing fee,charged on an annual basis as a percentage of assets, which is used tocover any marketing expenses incurred by the management company.A charge to exit a fund is called a back-end load or a redemption fee 12. An investor is contemplating buying a load fund versus a no load mutual fund. She is trying to figure out the actual amount she will have tospend on the load fund. The shares have a net asset value (NAV) of $34.50and a load of 5.2%. Determine which type of fund will always have a shareprice equal to the NAV and the price she will pay for the load fund. Fund Offering Price A)open-end $34.50 B)open-end $36.39 C)close-end $36.39
Explanation — (B) The share price of an open-end fund will alwaysequal the NAV, since the investment company is obligated to redeemshares at any time at current market value.Offering price = $34.50 / (1 – 0.052) = $36.39 13. A closed-end fund: A)has its price determined by the net asset value (NAV). B)has its price determined by supply and demand, regardless of its netasset value (NAV). C)is traded in the primary market but not the secondary market. Explanation — (B) Closed-end investment companies are initiatedthrough a stock offering to raise funds. The investment company doesnot issue or redeem shares after the initial offering. Shares of aclosed-end investment company are traded in public markets and arepriced by supply and demand. The share price of a closed-end fund isnot directly linked to the fund’s NAV. The NAV is the prevailing marketvalue of all the shares and assets owned by the fund. Many closed-endfunds sell at a discount of 5 to 20% from their NAV 14. Open-end investment companies: A)can continue to sell and repurchase shares after their initial publicofferings. B)must register a maximum number of shares with the Securities andExchange Commission (SEC).C)must redeem shares at the net asset value with no fees included Explanation — (A) The primary difference between open-end andclosed-end funds is that open-end funds continue to sell andrepurchase shares after their initial public offerings. Open-endinvestment companies can be load or no-load
15. Which statement about mutual funds is most accurate? A)The liquidity of an open-end fund is provided by the open market. B)The redemption fee for a closed-end fund is the commissioncharged on the sale and a portion of the bid/ask spread of the shares. C)Some open-end funds charge no fees Explanation — (B) Since closed-end funds are traded in the secondarymarket for a price determined by supply and demand for shares, thespread along with the sales commission represent the redemption fee.All funds charge fees, although the fees vary widely from fund to fund.In addition, some funds charge a load in addition to fees. The liquidityof an open-end fund is provided by the company that manages it, notthe open market 16. Which statement is the least accurate analysis of a mutual fund equity investment strategy? A)Stable value funds invest in long-term fixed-income securities withregular cash flows and a steady interest rate. B)Sector funds may set performance targets drastically different than theoverall market’s expected returns.C)Global funds managed by U.S. investment companies often contain U.S.stocks Explanation — (A) Stable value funds seek both timely principalpayments and steady interest rates, but tend to invest in short-termsecurities with regular principal payments. Global funds frequentlycontain stocks from the investment manager’s home country. Indexfunds are designed to track a certain index, and fees are typicallylower than those of actively managed funds. Because differentindustry sectors have different growth characteristics, some sectorfunds’ targets will of necessity diverge from the broader market
17. The Big Fund is a mutual fund that invests primarily in the equity of pharmaceutical companies. The investment style of the Big Fund can bestbe classified as a: A)style strategy.B)large-cap strategy. C)sector strategy. Explanation — (C) A large-cap strategy focuses on the equities ofcompanies with large capitalization. Both large cap and growth areexamples of style strategies, which look for investments with commonunderlying characteristics. A sector strategy invests in one, definedindustry 18. Growth, value, large-cap, and small-cap investing are all examples of: A)style investment strategies. B)sector investment strategies.C)index investment strategies Explanation — (A) A sector strategy invests in the stocks of aparticular industry. An index strategy models the portfolio to mimicthe benchmark index. A style strategy looks for investments withcommon underlying characteristics 19. A portfolio that pursues a stable-value investment strategy would most likely invest in: A)low P/E stocks. B)short-term Treasuries. C)high P/E stocks Explanation — (B) Investing in low P/E stocks is a value strategy.Buying high P/E stocks is a growth strategy. A stable-value fund wouldbe most likely to invest in short-term, fixed-income securities
20. A primary advantage of the in-kind redemption process of exchange traded funds (ETFs) is that it: A)provides greater liquidity for shares of the ETF.B)reduces transaction costs for the investor. C)reduces tax liability Explanation — (C) ETFs are typically cost-effective for the investorbecause they are passively managed and therefore have lowermanagement fees than actively managed portfolios. The in-kindprocess has no effect on the liquidity of the ETF shares. The in-kindprocess does reduce asset turnover, because shares do not have to besold in order to satisfy the redemption of shares 21. Which of the following risks are specific to exchange traded funds (ETFs) that are allowed to purchase derivatives? A)Tracking error risk. B)Credit risk.C)Market risk Explanation — (B) All ETFs are subject to market risk just like anyother diversified portfolio. Tracking error risk is always present in anindex fund. Only those ETFs that utilize a derivatives strategy will besubject to credit risk 22. Which of the following is least likely an advantage of exchange traded funds (ETFs) over traditional mutual funds? A)ETF shares have smaller bid-ask spreads than open-end mutualfunds. B)The structure of ETFs prevents share prices from trading at a significantpremium/discount to net asset value (NAV).
C)ETF shares trade throughout the day at continuously updated prices,while open-end funds trade only once a day at close-of-market prices Explanation — (A) ETF shares do trade continuously throughout theday, unlike shares of open-end funds. Investors in ETFs do have lowercapital gains liabilities than investors in open-end funds because ofETF’s in-kind redemption feature. Because of the in-kindcreation/redemption process of ETFs, new shares will be issued orredeemed in accordance with investor demand, thus eliminating anysignificant discount or premium. Because ETF shares trade on theopen market, the shares are subject to a bid-ask spread, whileopen-end funds trade at NAV and are not subject to a bid-ask spread 23. Which statement about the advantages and disadvantages of exchange-traded funds (ETFs) is least accurate? A)ETFs represent an attractive diversification tool, but investorscannot check their composition daily. B)Most ETFs have low fees, but some may cost more to trade because ofhigh bid/ask spreads.C)ETFs offer less capital-gains tax liability than open-end funds. Explanation — (A) ETFs are a useful diversification tool, and investorscan check their composition at any time. ETFs generally charge lowfees, but some with low trading volume may be costly to trade. ETFsincur less tax liability than open-end funds 24. Demand for real estate is a function of all of the following factors EXCEPT? A)Population characteristics of the community. B)Competitive properties. C)The terms and conditions of mortgage financing.
Explanation — (B) This is a determinant of the supply of real estateproperty. Both remaining choices are determinants of demand 25. Which of the following is least likely to be a form of real estate investment? A)Aggregation vehicles. B)Property insurance. C)Leveraged equity position. Explanation — (B) Property insurance is not considered a category ofreal estate investment because the underlying real estate does notrevert to the insurer if the property holder allows the policy to lapse.A leveraged equity position and aggregation vehicles such as realestate investment trusts are each forms of real estate investment 26. Mortgages are considered to be a form of real estate investment because: A)the investor receives a constant stream of cash flows. B)if the borrower defaults on the loan, the lender may end up owningthe property. C)the borrower will own the property at the end of the loan term. Explanation — (B) It is true that the borrower will own the property ifall loan terms are met, but the question is stated in terms of themortgage lender, not the borrower. The investor anticipates a constantstream of cash flows, similar to other fixed income investments, but isalso subject to defaults as well as prepayments. If the borrowerdefaults on the terms of the loan, the property will revert back to thelender, and this exposure is the reason why mortgages are considereda real estate investment
27. Investors can diversify their direct real estate holdings through all of the following vehicles EXCEPT: A)commingled funds. B)co-operative shares. C)limited partnerships. Explanation — (B) Real estate co-operatives are generally a tool withwhich multiple owners can purchase shares in a single building orcomplex. This strategy spreads out risk among many investors butdoesn’t offer much in the way of diversification for a single investor.Commingled funds and limited partnerships typically allow investorsto spread their bets either geographically or through differentproperty types 28. Which of the following least likely affects a property’s investment potential? A)Structure of the financing mechanisms used to buy the property. B)The legal rights associated with the property.C)The activity around the property, both commercial and non-commercial. Explanation — (A) The financing and investing decisions are madeseparately. Market value analysis does not consider how the asset willbe financed 29. Which of the following is least likely a disadvantage of the cost approach method of estimating the market value for real estate? A)market value of a property may differ significantly from its constructioncost. B)the replacement cost of existing improvements may be difficult todetermine. C)estimating the value of the land may be difficult.
Explanation — (B) The market value may be more or less than what itwould cost to rebuild or replace it. Estimating the value of the landportion of a property with improvements is a difficult process. Thereplacement cost is usually easy to determine, although it may or maynot reflect the value of the improvements 30. Consider the following descriptions of approaches used in valuing real estate:Approach 1: This approach relies on examining recent transaction pricesfrom a group of similar properties.Approach 2: This approach suggests that projects with positive expectednet present value should be accepted.Approach 3: In this approach, an estimate for net operating income isdiscounted by an estimate of the market required rate of return to obtainthe appraisal price.Approach 4: In this approach an estimate for the value of land is added tothe price tag that would have to be paid if a property had to be replaced. List in order from Approach 1 to Approach 4 the real estate valuationmethod that corresponds to each of the four valuation approaches listedabove. A)The sales comparison method; the income method; the cost method andthe discounted after-tax cash flow model. B)The sales comparison method; the discounted after-tax cash flowmodel; the income method and the cost method. C)The income method; the cost method; the sales comparison method andthe discounted after-tax cash flow model. Explanation — (B) The approach that relies on examining recenttransaction prices from a group of similar properties is the salescomparison method. The approach that suggests that projects withpositive expected net present value should be accepted is thediscounted after-tax cash flow model. The approach that requires anestimate for net operating income which is subsequently discountedby an estimate of the market required rate of return to obtain the
appraisal price is the income method and the approach that adds anestimate for the value of land to the price tag that would have to bepaid if a property had to be replaced is the cost method 31. Consider the following descriptions of approaches used in valuing real estate:Approach 1: In this approach, the present value of after-tax cash flows arecalculated based on the investor’s required rate of return before the equityportion of the investment is deducted.Approach 2: In this approach, the value of land is estimated and is added tothe price that would have to be paid if a property had to be replaced.Approach 3: In this approach, an appraisal price is estimated as thediscounted net operating income based on the market required rate ofreturn.Approach 4: This approach relies on examining recent transaction pricesfrom a group of similar properties and depends on a reasonably liquidmarket. List in order, from Approach 1 to Approach 4, the real estate valuationmethods that correspond to each of the four valuation approaches listedabove. A)The income method, the cost method, the sales comparison method, andthe discounted after-tax cash flow model. B)The discounted after-tax cash flow model, the cost method, theincome method, and the sales comparison method. C)The income method, the discounted after-tax cash flow model, the salescomparison method, and the cost method Explanation — (B) The approach that suggests that the present valueof after-tax cash flows be calculated based on the investor’s requiredrate of return before the equity portion of the investment is deducted,is the discounted after-tax cash flow model. The approach that adds anestimate for the value of land to the price tag that would have to bepaid if a property had to be replaced, is the cost method. The approachthat requires an estimate for net operating income (NOI) which is
subsequently discounted by an estimate of the market required rate ofreturn to obtain the appraisal price, is the income method. Finally, theapproach that relies on examining recent transaction prices from agroup of similar properties, is the sales comparison method. Theaccuracy of this method depends on there being a liquid real estatemarket from transactions data that can be collected 32. Which of the following is least likely a characteristic of the income method for real estate valuation? A)Account for the effects of income taxes. B)Require a discounted cash flow model.C)Ignore future changes in operating income. Explanation — (A) The income method does not consider theinvestment’s income-tax implications. However, it does use adiscounted cash flow model based on net operating income. Theincome method does not account for potential changes in operatingincome 33. Which of the following statements regarding real estate valuation is CORRECT? A)Each property is unique, so the investment value may be dependentupon the particular use planned for the property. B)The estimated market value of a property depends upon the particularinvestor.C)The most reliable real estate valuation method is the cost approach Explanation — (A) The market value is completely independent of anyconsiderations based upon the investor or potential investor. There isnot a “most reliable” valuation method – all have their advantages anddisadvantages. The investment value may be dependent upon theplanned use of the property—remember that market value andinvestment value are two different things
34. Jill Booton is evaluating an apartment building as a possible investment to add to her portfolio. She has been told that real estate is a good additionto a portfolio for diversification purposes. Jill will not be able to handle themaintenance issues at the complex and thus must hire a full-timemaintenance employee at $35,000 per year. She will also hire a full-timemanager at $40,000 per year. Property taxes are expected to be $75,000 peryear and insurance will be another $25,000. If fully occupied, the grossrental income from the property will be $850,000. Due to the location of thebuilding, Jill estimates a very low vacancy rate of 3.5 percent annually. Thenet operating income of the property is closest to: A)$825,250.B)$4,963,462. C)$645,250. Explanation — (C) NOI = $850,000 – ($850,000 x 0.035) – $35,000 –$40,000 – $25,000 – $75,000 = $645,250 35. Based upon the following information, what is the net operating income (NOI) of the property?Estimated Market Value $600,000Capitalization Rate 20%Taxes $27,000Operating Expenses $107,000 A)$120,000. B)$104,000.C)$98,600. Explanation — (A) MV = NOI / CAPTo solve for NOI, rewrite the formula as: MV × CAP = NOI600,000 × 0.2 = 120,000
36. The income approach to valuing real estate is most similar to the following method of valuing common stock? A)Dividend discount model with zero growth. B)Dividend discount model with normal growth.C)Price-to-sales ratio. Explanation — (A) The income approach for valuing real estate usesthe following formula:Appraised Pricereal estate = annual net operating income (NOI) /Market Capitalization Rate (R)The dividend discount model (DMM) with zero growth approach forvaluing common stock uses the following formula:Pricecommon stock = Dividend (D) / (Required Rate of Return on theStock (k) - Growth (g))When g = 0, the formulas simplify to:Appraised Pricereal estate = NOI / RPricecommon stock = D / kor, a period cash flow divided by a rate of return.The DMM with normal growth would not be a correct responsebecause the income approach for real estate assumes a constant (nogrowth) NOI stream to perpetuity 37. Managers of hedge funds are typically compensated by: A)an incentive fee, paid only if performance exceeds a “high water mark”.B)a management fee, based on the net change in value of the assets duringthe year. C)a base management fee, based on the value of assets undermanagement, plus an incentive fee, based on profits Explanation — (C) Typical arrangements pay the manager a base fee,usually around 1% of assets, plus an incentive fee proportional toprofits.
38. To avoid most SEC regulations, hedge funds organized in the United States typically operate within all of the following guidelines EXCEPThedge: A)funds may accept a maximum number of investors. B)fund investments by individuals are limited to a maximum of$500,000. C)fund managers are prohibited from advertising or marketing the fund Explanation — (B) Hedge funds organized under section 3(c) (7) ofthe Investment Company Act may not advertise, must limit the numberof investors to 500, and may only accept “qualified” investors, asdefined by the Act. Hedge funds investments are not subject to amaximum amount 39. Which of the following statements describing hedge funds is least accurate? Most hedge funds: A)use hedging techniques to reduce risk. B)are exempt from most securities regulations.C)are available to only a limited number of qualified investors. Explanation — (A) The term “hedge fund” is an inaccurate descriptionof the investment class because these funds may or may not employhedging techniques. Most hedge funds are organized so as to remainexempt from most securities regulations. Participation typicallyrequires a large minimum investment and is limited to small numbersof qualified investors 40. A hedge fund that takes perfectly offsetting long and short positions is best described as a(n): A)long/short fund. B)market-neutral fund. C)event-driven fund.
Explanation — (B) Market-neutral funds take long and short positionsbut attempt to offset them to hedge against market moves. Long/shortfunds take both long and short positions but do not try to offset them.Event-driven funds focus on unique market opportunities, notoffsetting positions. 41. The largest category of hedge funds in terms of asset size is: A)market-neutral funds. B)long/short funds. C)global macro funds. Explanation — (B) Long/short funds are considered to be the“traditional” type of hedge funds, and they represent the largestcategory of hedge funds 42. Which of the following statements best describes the fund-of-funds (FOF) class of hedge funds? A fund of funds: A)is an open-end mutual fund that primarily invests in other open-endfunds.B)is open to institutional investors for the purpose of seeking arbitragesituations in hedge fund pricing. C)allows smaller investors to access the hedge funds market Explanation — (C) A FOF is a fund that invests in hedge funds. They areopen to both individual and institutional investors 43. One of the main advantages to investing in a fund of funds (FOF) is that compared to investing in a single hedge fund, FOFs provide: A)improved diversification of assets. B)higher expected returns.
C)lower management fees. Explanation — (A) FOFs have higher management fees than singlehedge funds because the FOF will charge a fee in addition to the feecharged by the hedge fund manager. FOFs actually have lowerexpected returns because of the cost of their increased diversification.FOFs can diversify across many hedge funds strategies to decrease risk 44. Which of the following is least likely considered a benefit of the fund-of-funds hedge fund structure? A)The fund-of-funds manager has the expertise needed to evaluate andconduct due diligence on individual hedge funds.B)A fund of funds may have access to hedge funds that are closed to newinvestors. C)Similar to index funds, a fund of funds charges investors lower feesthan individual hedge funds Explanation — (C) Funds of hedge funds charge investors amanagement fee in addition to the fees charged by each hedge fundmanager. This double layer of fees is the primary drawback of a fundof funds. The other choices are likely benefits of fund-of-fundsinvesting 45. Which of the following strategies is least likely to be used by a hedge fund to increase leverage? A)Borrowing external funds.B)Margin borrowing. C)Pursuing arbitrage opportunities Explanation — (C) Borrowing through a margin account andborrowing external funds are methods commonly used by hedge fundsto increase leverage. Hedge funds are generally allowed to pursuearbitrage opportunities, which may or may not increase leverage
46. In periods of high volatility, hedge funds may encounter broker-dealers that adopt policies of extremely conservative marking-to-market of fundassets. This is called: A)counterparty risk. B)pricing risk. C)settlement risk. Explanation — (B) Counterparty risk is the exposure to thecreditworthiness of the broker-dealers that hedge funds transact with.Settlement risk describes the risk that a counterparty, such as abroker-dealer, fails to deliver a security as agreed. Pricing risk occurswhen broker-dealers, in order to protect themselves, adopt extremelyconservative pricing policies, which in turn requires hedge funds topost a greater margin 47. Biases in hedge fund performance measurement are least likely to include: A)incomplete historical data.B)smoothed pricing. C)correlation bias. Explanation — (C) The six most common biases present in hedgefunds are: “Cherry Picking” by managers. Incomplete historical data.Survival of the fittest. Smoothed pricing. Asymmetrical returns. Feestructures and incentives 48. Which of the following statements regarding hedge fund performance is NOT correct? A)Hedge funds have historically underperformed the S&P 500.
B)Hedge funds have demonstrated a lower risk profile than traditionalequity investments.C)The Sharpe ratio for hedge funds has been consistently higher than formost traditional equity investments. Explanation — (A) Hedge funds have demonstrated a lower riskprofile than equities when measured by standard deviation. TheSharpe ratio, which is a reward-to-risk ratio, has been higher forhedge funds than for equities. Hedge funds have historicallyoutperformed the S&P 500 49. The fee structure of a hedge fund may lead to biases in performance data because: A)hedge fund managers are not required to disclose information regardingfee structures.B)hedge fund managers charge higher fees than managers of traditionalfunds. C)fund managers have incentives to take big risks if past performancehas been poor. Explanation — (C) Hedge fund managers have the potential to earnmore than managers of traditional funds, but this does not biasperformance data. Hedge fund managers typically receive a modestbase fee (1%) and then a large incentive fee based upon performance.If past performance has been poor, then fund managers feel they have“nothing to lose” and may invest more aggressively 50. Hedge fund performance data suffers from serious biases that can be attributed to the fact that: A)there is not a reliable index that tracks hedge fund performance.B)hedge funds as an asset class have not been in existence long enough tohave meaningful performance data. C)fund managers tend to submit only favorable performance data
Explanation — (C) Hedge funds have been in existence since the early1990’s, long enough to compile meaningful data. There are severalreliable indexes designed to track hedge funds. One of the primaryreasons why performance data has biases is that submission is strictlyvoluntary, so managers tend to only submit impressive performanceinformation 51. Which of the following statements regarding survivorship bias in hedge funds is most accurate? Survivorship bias tends to: A)overstate the performance and understate the volatility of hedgefunds. B)overstate both the performance and volatility of hedge funds.C)understate the performance and overstate the volatility of hedge funds. Explanation — (A) Survivorship bias exists because only thesuccessful hedge funds submit performance data, thus overstatingperformance when the index is considered to be representative of theentire hedge fund population. Likewise, stable funds tend to succeed,while more volatile funds tend to go out of business, causing thedatabase to tend to understate volatility for hedge funds as an assetclass 52. Survivorship bias is acute with hedge fund databases because hedge: A)funds experience higher volatility of returns than traditionalinvestments.B)funds are more highly leveraged than other asset classes. C)fund managers often do not have to comply with performancepresentation standards Explanation — (C) The main reason behind the survivorship biasproblem in hedge fund reporting is that hedge funds are exempt frommost SEC regulations, including performance presentation standards.
This lack of standards leads to many inconsistencies in reporting thatare not present in other asset classes 53. Only successful, ongoing hedge funds are included in hedge fund databases. The resulting inflation of reported hedge fund performance canbe best described as: A)survivorship bias. B)asymmetrical returns.C)self-selection bias. Explanation — (A) Asymmetrical returns refers to the option-likereturn profiles that result from some hedge fund strategies.Self-selection bias reflects the fact that submission of data by fundmanagers is voluntary, and they tend to submit only impressiveresults. Survivorship bias does result from the fact that only successfulhedge funds with ongoing operations are included in databases, thusputting an upward bias on the returns of hedge funds as an asset class 54. Hedge funds are generally not required to publicly disclose their performance, however, some managers choose to make performanceinformation available to the public. This information is then included inhedge fund indexes and some conclusions about the performance of hedgefunds can be drawn. Which of the following statements regarding hedgefund performance is least accurate? A)When measured by standard deviation, hedge funds are less risky thantraditional equity investments.B)In recent years, the Sharpe ratio for hedge funds has been higher thanthat of most equity investments. C)The reported volatility of hedge fund returns may be higher thanthe actual volatility of returns. Explanation — (C) Many assets that are included in a hedge fundportfolio are not actively traded. Managers utilize estimates to report
the market value and performance of their hedge funds. Usingestimates rather than actual market transactions may result insmoothed pricing, thereby reducing reported volatility