CFA Level 2 - Alternative Investments Session 13-Reading 47 (Practice Questions, Sample Questions) 1. Compared to a mutual fund, a hedge fund is most likely to have lower levels of: A)disclosure. (Explanation: Hedge funds are relatively unregulated, and haveminimal disclosure requirements. Unlike mutual funds, hedge funds are notsubject to limits on the use of leverage and derivatives) B)usage of derivatives.C)leverage 2. Compared to a mutual fund, a hedge fund is most likely to have lower: A)disclosure requirements. (Due to the unregulated nature of hedge funds, hedgefunds are required to provide only minimal disclosure to investors (and even lessdisclosure to non-investors). Hedge funds often have a one, two, or three yearlockup periods, while mutual funds generally have daily liquidity. Hedge fund feesare generally higher than mutual fund fees, because on top of a management fee(typically 2%), hedge funds also charge a performance fee (typically 20% ofproﬁts.)) B)lockup periods.C)fees 3. Alpha hedge fund limits withdrawals by investors during the ﬁrst three years by imposing a redemption fee of 3%. Such provisions by hedge funds are called:
A)hard lockup.B)regulatory disclosure. C)soft lockup (Lockups which allow for redemption on payment of penalty arecalled as soft lockup. Under hard lockup, withdrawals are not permitted) 4. A hedge fund with a ﬁxed-income arbitrage strategy is most likely to su er a loss when: A)credit spreads widen quickly. (Fixed-income arbitrage generally involves buyinghigh-yielding (low quality) bonds while selling low-yielding (high quality) bonds.Leverage can be used in place of selling high quality bonds. This strategy cansu er great losses when credit spreads widen quickly, when leverage becomesmore expensive, or when the markets for low-quality debt become less liquid) B)leverage becomes less expensive.C)markets for lower quality debt become more 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. (A merger arbitragestrategy is considered a “short volatility” strategy: this strategy will experience aloss if the expected merger is cancelled. This strategy involves purchasing thestock of the target company and shorting the stock of the acquiring company) C)involves purchasing the stock of an acquiring company 6. Which of the following is most accurate in describing the problems of survivorship bias and backﬁll bias in the performance evaluation of hedge funds?
A)Survivorship bias and backﬁll bias both result in downwardly biased hedge fund indexreturns. B)Survivorship bias and backﬁll bias both result in upwardly biased hedge fundindex returns. (The problem in survivorship bias is that only the returns forsurvivors will be reported and the index return will be biased upwards. Backﬁllbias results when a new hedge fund is added to an index and the fund's historicalperformance is added to the index's historical performance. The problem is thatonly funds that survived will have their performance added to the index, resultingin an upward bias in index returns) C)Survivorship bias results in upwardly biased hedge fund index returns, but backﬁllbias results in downwardly biased hedge fund 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. (Investors prefer a return distribution with low kurtosis, lowvariance, a high mean and positive skewness) C) high variance 8. Adding long volatility hedge fund strategies to a portfolio of short volatility hedge fund strategies is most likely to increase the attractiveness of the portfolio return’s: A)Sharpe ratio. B)skewness and kurtosis exposures. (Adding long volatility strategies to aportfolio of short volatility strategies would increase the volatility of portfolioreturns and decrease the portfolio’s Sharpe ratio. However, the resulting portfolioreturns distribution will be more normally distributed and skewness and kurtosischaracteristics of the return distribution will be more attractive to investors) C)reported volatility
9. Studies using factor models have generally found the largest contributor to hedge fund returns to be: A)traditional market factor exposures. (Studies have found that the majority ofhedge fund styles can be relatively closely replicated using traditional marketexposures such as stock and bond indices, currency, and commodity marketreturns. These traditional market risk factors have been found to explain 50%–80%of hedge fund returns) B)manager skill.C)exotic beta exposures 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. (Hedge fund factor models generally attribute hedge fund returnto the sum of alpha, the risk-free rate, and the sum of the impacts of the relevantrisk factors. If some of the relevant risk factors are omitted from the model, thealpha (return due to manager skill) is likely to be over-estimated) C)negative 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. (Investors should be concerned about hedgefund risk because hedge fund returns have fat tails on the left hand side of theirdistribution. In other words, the probability of large losses is greater than thatexpected from a normal distribution. For this reason, it is imperative that investors
evaluate a downside measure of risk, such as maximum drawdown and/or value atrisk) C)are normally distributed 12. The return distribution of a merger arbitrage strategy, in which the fund manager purchases the target company and shorts the acquiring company stock, is bestdescribed as: A)normally distributed.B)positively skewed. C)highly kurtotic (The returns of many hedge fund strategies – including mergerarbitrage trades – are not normally distributed; rather they are highly kurtotic andnegatively skewed) 13. Non-normality in hedge fund returns is most likely to cause performance to be: A)underestimated.B)zero. C)overestimated (Non-normality of hedge fund returns necessitates considerationof higher order moments of the return distribution—speciﬁcally skewness andkurtosis. For most hedge funds, the return distribution is negatively skewed andhighly kurtocic. These are undesirable qualities from the perspective of aninvestor. Ignoring these higher-order moments leads to overestimation ofperformance) 14. An investor considering investing in a hedge fund, would be most likely motivated in pursuing replicating strategy, rather than investing in the hedge fund directly when thehedge fund:
A)has a long lockup period. (Investors may be motivated to choose hedge fundreplication strategies over actual investments in hedge funds when: (1) hedgefund managers are not earning a positive alpha, (2) investors feel that the feespaid to hedge fund managers are not justiﬁed, and (3) investors have objections tohedge funds’ lack of transparency or liquidity) B)returns have a large alpha component.C)strategies are clearly disclosed 15. A di culty 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 (Traditional portfolio analysis calculates the moste cient portfolio using return, correlation and volatility of assets. However, it isdi cult to apply traditional portfolio analysis to hedge funds because: (1) it isdi cult to develop accurate expected returns, (2) hedge fund correlation, betaexposures, and volatility can change over time, and (3) standard deviation is not acomplete measure of hedge fund risk due to higher moment risks such asskewness and kurtosis. This is due to non-normal distribution of hedge fundreturns) 16. The usual result of adding hedge funds to a portfolio of traditional (stocks and bonds) investments is a decrease in: A)standard deviation. (The usual result of adding hedge funds to a portfolio oftraditional investments is that: (1) standard deviation will decrease, (2) the Sharperatio will increase, and (3) higher-moment exposures such as skewness andkurtosis will increase) B)Sharpe ratio.C)skewness and kurtosis
17. Compared to a single manager hedge fund, a fund of funds is most likely to have higher: A)management and performance fees. (Funds of funds generally have highermanagement and performance fees than single manager hedge funds becausefunds of funds generally apply a second layer of fees on top of those paid to theunderlying fund managers. Fund of funds’ returns tend to be equal to averagehedge fund index performance—before fund of funds’ second layer of fees arededucted. By investing in 15 or more single manager funds of various strategies(diversifying), funds of funds achieve lower standard deviation) B)return performance.C)standard deviation 18. Compared to a single manager hedge fund, a fund of funds is most likely to have higher: A)longevity. (Funds of funds generally have lower mortality, lower survivorshipbias, and lower backﬁll bias than single manager hedge funds) B)survivorship bias.C)backﬁll bias