READING NO.

58
ALTERNATIVE INVESTMENTS

Disclaimer: Certain materials contained within this text are the copyright property of CFA
Institute. The following is the source for these materials: “CFA® Program Curriculum
Level I Volume 6 Page No. 184 to 193”
READING NO. 58
ALTERNATIVE INVESTMENTS

Others
Private
Hedge fund Real estate Commodities Infrastructure e.g.:
Equity fund
painting

2
Real estate investment include:
Residential property
Commercial property
Loans with property as collateral
Shares of real estate companies / REITs
Timberland and farmland: These properties allow investors to generate income
through sales of the produced commodity or by leasing the land to another entity.
 Factors that drive returns for timberland include biological growth,
commodity price changes, and land price changes.
 The primary return drivers of return for farmland are harvest quantities,
commodity prices, and land price changes.
3
Particulars Equity Debt

Private • Direct ownership • Loans given to third parties directly

Public • Buying shares of real estate • Loans given to third parties, through
companies bank. Example: mortgage-backed
• Shares of REITs securities (to be covered in detail
under asset backed securities chapter
in Fixed Income)

4
Real Estate Performance and diversification benefits
• Appraisal indexes use estimates of value (based on comparable sales or DCF analysis) as inputs. Appraisals are
performed periodically, often annually, As a result, index returns are relatively smooth and tend to understate
volatility.
• Repeat sales (transactions-based) indexes are constructed using changes in prices of properties that have sold
multiple times over the period. These indexes suffer from sample selection bias, as the sample of properties used
may not be representative of the entire set of properties available.
• REIT indexes are constructed using prices of publicly traded shares of REITs.

 Studies have shown that real estate as an asset class enjoys less than perfect positive correlation with stocks and
bonds, so there may be diversification benefits to adding real estate investments to a portfolio containing
traditional investments.
 The correlation between real estate and equities is higher than the correlation between real estate and bonds
because real estate and equities are affected similarly by the business cycle.
 It serves as an inflation hedge if rents can be adjusted quickly for inflation.

5
Real Estate Valuation
• Comparable sales approach

• Income approach: Two income-based approaches to real estate valuation are the direct capitalization
approach and the discounted cash flow (DCF) approach.
• The direct capitalization approach estimates the value of a property by dividing expected net operating income (NOI)
generated by the property by a growth implicit capitalization rate (also referred to as the cap rate). Generally, when
income and value are growing constantly at the same rate, the cap rate equals the discount rate minus the growth
rate. The cap rate is based on cap rates on sales of comparable properties, general business conditions, property
quality, and the quality of management.
• The discounted cash flow approach estimates the value of a property as the present value of its expected future cash
flows over a specific investment horizon plus the present value of an estimated resale value (or reversion value) at
the end of the holding period.

• Cost approach: Under this approach the value of a property is estimated as its replacement cost, which equals
the total cost that would be incurred to buy the land and construct a new, but similar, property on that site.

6
REIT Valuations
• Income-based approaches for valuing REITs are similar to the direct capitalization
approach for valuing individual properties (described previously) in that a measure of
income is capitalized into a value using an appropriate cap rate. Two common
measures of income used are:
• Funds from operations (FFO): This is calculated as net income plus depreciation
charges on real estate property (because it is a noncash charge and is often unrelated to
the actual value of the property) less gains from sales of real estate property plus losses
on sales of real estate property (as these are assumed to be non-recurring).
• Adjusted funds from operations (AFFO): This is calculated by adjusting FFO for
recurring capital expenditures (so it is similar to a measure of free cash flow).
• Asset-based approaches

7
Commodities
• Exchange-traded funds (ETFs): These are suitable for investors who are
limited to only investing in equities. ETFs may invest in commodities
or commodity futures. Further, they may use leverage, and their expense
ratios are typically lower than those for most mutual funds.
• Common stock of companies exposed to a particular commodity
• Managed futures funds: These are actively managed investment funds
that may focus on specific commodity sectors or be broadly diversified.
• Individual managed accounts

8
Commodity Performance and Diversification Benefits
• Commodities earned a lower annual return than stocks and bonds.
• Commodity returns had a higher standard deviation (risk) than stocks and
bonds.
• As a result, the Sharpe ratio for commodities as an asset class was much lower
than for stocks and bonds.

commodities have a relatively low correlation with stocks and bonds, which
suggests that there are diversification benefits
hedge against inflation
9
Commodity valuation
The price of a futures contract on a commodity may be calculated as follows:
Futures price = Spot price × ( 1 + Risk-free short-term rate) + Storage costs −
Convenience yield
There are three sources of return on a commodity futures contract:
• Roll yield: The difference between the spot price of a commodity and the futures
price, or the difference between the futures prices of contracts expiring at different
dates.
• Collateral yield: The interest earned on the collateral (margin) deposited to enter into
the futures contract.
• Spot prices: These are influenced by current supply and demand.
10
Infrastructure
• Investing in
• Transportation assets such as roads, airports, railways
• Utility assets such as power generation
• Communications such as broad cast assets and cable systems
• Social such as schools, health care facilities
• Brownfield: stable cash flows, relatively high yields, however, little potential for growth.
• Greenfield

• Direct investments
• Indirect investments include shares of (1) companies, (2) exchange-traded funds, (3) mutual funds, (4)
private equity funds, and (5) master limited partnership
• Investors who are most concerned about liquidity may choose to invest through (1) publicly traded infrastructure securities
and/or (2) master limited partnerships (MLPs).
• In addition to liquidity, publicly traded infrastructure securities provide reasonable fees, transparent governance,
market prices, and the ability to diversify across underlying assets.

11
Infrastructure
• Master limited partnerships (MLPs) trade on exchanges and are
pass-through entities similar to real estate investment trusts
(REITs).
• Most of the free cash flow is passed on to investors. However,
investors are liable for taxes on that income.
• Typically, a general partner manages the partnership, receives a
fee, and holds a small partnership interest. Limited partners
own the remaining partnership interest.
12
Other alternative investment, e.g.: paintings,
antique furniture
• No income generation
• Storage cost is significant
• Specialized knowledge is required

13
Hedge funds: structured as LLP and are less
regulated
Leverage
Short equity
Take long or short position in derivatives

14
Fund of funds: investment company
Fee structure
• Asset under management
• Profits
• Hurdle rate (soft/hard)
• High water mark
15
• AWJ Capital is a hedge fund with $100 million of initial investment capital. It charges a 2% management fee based on
year-end AUM and a 20% incentive fee. In its first year, AWJ Capital has a 30% return. Assume management fees are
calculated using end-of-period valuation.
1. What are the fees earned by AWJ if the incentive and management fees are calculated independently? What is an
investor’s effective return given this fee structure?
2. What are the fees earned by AWJ assuming that the incentive fee is calculated based on return net of the management fee?
What is an investor’s net return given this fee structure?
3. If the fee structure specifies a hurdle rate of 5% and the incentive fee is based on returns in excess of the hurdle rate, what
are the fees earned by AWJ assuming the performance fee is calculated net of the management fee? What is an investor’s
net return given this fee structure?
In the second year, the fund value declines to $110 million.
4. The fee structure is as specified for Question 1 but also includes the use of a high-watermark (computed net of fees). What
are the fees earned by AWJ in the second year? What is an investor’s net return for the second year given this fee
structure?
In the third year, the fund value increases to $128 million.
5. The fee structure is as specified in Questions 1 and 4. What are the fees earned by AWJ in the third year? What
is an investor’s net return for the third year given this fee structure?

16
Potential benefits and risks
• Less than perfect correlation offers
diversification
• Correlation trend to increase during periods of
financial crisis
• Perform better than equity market in down
conditions and lag equity market in up markets
17
 Valuation
• Market values are used to value traded securities in hedge fund portfolios, but estimated
values are used for non-traded securities.
• It is theoretically more accurate to use the bid prices for long positions and ask prices for
short positions.
• For highly illiquid or non-traded investments, reliable market value data are unavailable, so
values are estimated using statistical models. Even if quoted market prices are available,
hedge funds may apply “haircuts” to quoted prices to reflect a liquidity discount. However,
since this goes against most generally accepted accounting principles, some funds have
started reporting two net asset values (NAVs): a trading NAV and a reporting NAV.
• The trading NAV is based on the size of the position held relative to the total amount
outstanding in the issue and its trading volume.
• The reporting NAV is based on quoted market prices.

18
 Due diligence
• Investment strategy.
• Investment process.
• Competitive advantage.
• Track record.
• Size and longevity.
• Management style.
• Key-person risk.
• Reputation.
• Investor relations.
• Plans for growth.
• Methodology used for return calculations.
• Systems for risk management.

19
 Hedge fund strategies
 Event driven strategies
 Merger arbitrage
 Distressed
 Activist shareholder
 Special situation
 Equity hedge fund strategies
 Fundamental value
 Fundamental growth
 Quantitative directional
 Short bias
 Market neutral
 Macro strategy: Take a top-down view as they focus on the overall macroeconomic environment, taking
long and short positions in broad markets (e.g., equity indexes, currencies, commodities, etc.) that are
expected to benefit based on the manager's view regarding overall market direction.

20
Hedge fund strategies
 Relative value strategies
 Fixed-income convertible arbitrage: These strategies
seek to exploit a perceived mispricing between a
convertible bond and its component parts (the straight
bond and the embedded option on the stock). They
typically involve purchasing convertible bonds and
selling the same issuer's common stock.
21
Hedge fund indexes may be inherently biased upward due to self-
selection bias, backfill bias, and survivorship bias.
 Self-selection bias: Since disclosure of performance data to hedge fund
indexes is voluntary, fund managers tend to reveal their performance
only if it is impressive.
 Backfill bias: When a fund's performance is included in an index, its past
performance is also included in the database.
 Survivorship bias: This occurs due to the fact that unsuccessful funds
tend to go out of business and only well-performing funds are willing to
disclose their historical performance for inclusion in hedge fund indexes.

22
Private Equity Fund
Equity of companies that are not listed
Public companies planning to become
private: Leveraged buyouts
Venture capital: start ups
Distressed investment
23
Leveraged buyouts: most common type of
private equity
Convertible debt
Bank debt High yield bonds
(mezzanine)
• Carry conversion features
• Subordinate to high yield
bonds

24
Types of leveraged buyouts
Management Management
buyouts buy-ins

Attractive LBO companies

Low debt (already)
High cash flows
25
Venture capital: Start-ups
Formative IPO
Later stage
stage (Mezzanine)

Angel Seed Early • Expansion of production • Prepare for IPO

•Idea •Marketing •Commercial

•Individuals •Market production
are research and sales
interested •Venture
fund enters

26
• Distressed investing:
• Buying debt of mature companies
• Investors take an active role in management

27
• Structure and fees
• Committed capital • Management fees: 1 to 3% of • Incentive fees
• Drawdown capital committed capital • 20% of profits
• Not earned until the
fund has returned the
initial capital
• Claw back provision

28
• Exit strategies
IPO
Secondary sale: another private equity firm
Trade sale: strategic buyer
Write off
Recapitalization: not an exit strategy
29
• Potential benefits and risks
 Return higher than stock market
 Less than perfect correlation
 Higher standard deviation
 Infrequently traded, correlation and standard deviation, biased
downward
 Overstated returns (to be discussed under hedge funds)
 Survivorship bias
 Back fill bias
30
• Valuation
 DCF
 Multiple
 Asset based

31
Compare alternative investments with traditional investments.
• Traditional investment: Long-only positions in stocks, bonds and cash.
• Alternative: Hedge funds, private equity funds, real estate, commodities, etc.
• Investments in Hedge funds and private equity are generally characterized by:
• High fees, large size of investments, low diversification of managers and investments
within the alternative investment portfolio, high use of leverage, restrictions on
redemptions.
• Other characteristics that are common to many alternative investments include:
• Illiquidity of underlying investments, narrow manager specialization, low correlation
with traditional investments, low level of regulation and less transparency, limited
and potentially problematic historical risk and return data, unique legal and tax
considerations.

32
Describe risk management of alternative investments.
• Given the illiquid nature of most alternative investments, estimates of value (as opposed to
actual transaction prices) may be used for valuation purposes. As a result, returns data may
be smoothed and the standard deviation of returns may be understated. In addition, the
distribution of returns for most alternative investments is non-normal. Returns generally
tend to be leptokurtic and negatively skewed (positive average returns but with higher than
average risk of extreme losses). As a result, measures of downside risk are more useful.
Downside risk measures focus on the left side of the returns distribution curve. They
include:
 Value at risk (VaR): This estimates the minimum amount of loss expected over a given time
period at a given probability.
 Sortino ratio: This measure of downside risk uses downside deviation as opposed to
standard deviation as a measure of risk.
33
• Private equity funds are most likely to use:
A. merger arbitrage strategies.
B. leveraged buyouts.
C. market-neutral strategies.

B is correct. The majority of private equity activity involves leveraged buyouts. Merger arbitrage
and market neutral are strategies used by hedge funds.

34
• An investor may prefer a single hedge fund to a fund of funds if he seeks:
A. due diligence expertise.
B. better redemption terms.
C. a less complex fee structure.

C is correct. Hedge funds of funds have multi-layered fee structures, while the fee structure for a
single hedge fund is less complex. Funds of funds presumably have some expertise in conducting
due diligence on hedge funds and may be able to negotiate more favorable redemption terms than
could an individual investor in a single hedge fund.

35
• Hedge funds are similar to private equity funds in that both:
A. are typically structured as partnerships.
B. assess management fees based on assets under management.
C. do not earn an incentive fee until the initial investment is repaid.

A is correct. Private equity funds and hedge funds are typically structured as partnerships where
investors are limited partners (LP) and the fund is the general partner (GP). The management fee for
private equity funds is based on committed capital whereas for hedge funds the management fees are
based on assets under management. For most private equity funds, the general partner does not earn
an incentive fee until the limited partners have received their initial investment back.
36
• Both event-driven and macro hedge fund strategies use:
A. long–short positions.
B. a top-down approach.
C. long-term market cycles.

A is correct. Long–short positions are used by both types of hedge funds to potentially profit from
anticipated market or security moves. Event-driven strategies use a bottom-up approach and seek to
profit from short-term events typically involving a corporate action, such as an acquisition or a
restructuring. Macro strategies seek to profit from expected movements in evolving economic
variables.
37
• Hedge fund losses are most likely to be magnified by a:
A. margin call.
B. lockup period.
C. redemption notice period.

A is correct. Margin calls can magnify losses. To meet the margin call, the hedge fund manager may
be forced to liquidate a losing position in a security, which, depending on the position size, could
exert further price pressure on the security, resulting in further losses. Restrictions on redemptions,
such as lockup and notice periods, may allow the manager to close positions in a more orderly
manner and minimize forced-sale liquidations of losing positions.
38
• The first stage of financing at which a venture capital fund most likely invests is the:
A. seed stage.
B. mezzanine stage.
C. angel investing stage.

A is correct. The seed stage supports market research and product development and is generally the
first stage at which venture capital funds invest. The seed stage follows the angel investing stage. In
the angel investing stage, funds are typically provided by individuals (often friends or family), rather
than a venture capital fund, to assess an idea’s potential and to transform the idea into a plan.
Mezzanine-stage financing is provided by venture capital funds to prepare the portfolio company for
its IPO.
39
• An equity hedge fund following a fundamental growth strategy uses fundamental
analysis to identify companies that are most likely to:
A. be undervalued.
B. be either undervalued or overvalued.
C. experience high growth and capital appreciation.

C is correct. Fundamental growth strategies take long positions in companies identified, using
fundamental analysis, to have high growth and capital appreciation. Fundamental value strategies use
fundamental analysis to identify undervalued companies. Market-neutral strategies use quantitative
and/or fundamental analysis to identify under- and overvalued companies.

40
• Which of the following is most likely to be available when conducting hedge fund
due diligence?
A. The benchmark used by the fund
B. Information on systems risk management
C. Details of investment strategies and processes

A is correct. It should be possible to identify the benchmark against which the fund gauges its
performance in the hedge fund due diligence process. It should also be possible to establish the range
of markets in which the fund invests as well as the fund’s general strategy. Hedge funds consider
their strategies, systems, and processes to be proprietary and are unwilling to provide too much
information to potential investors.

41
• A private equity fund desiring to realize an immediate and complete cash exit from a
portfolio company is most likely to pursue a(n):
A. IPO.
B. trade sale.
C. recapitalization.

B is correct. Private equity funds can realize an immediate cash exit in a trade sale. Using this
strategy, the portfolio company is typically sold to a strategic buyer.

42
• A hedge fund invests primarily in distressed debt. Quoted market prices are available
for the underlying holdings but they trade infrequently. Which of the following will
the hedge fund most likely use in calculating net asset value for trading purposes?
A. Average quotes
B. Average quotes adjusted for liquidity
C. Bid prices for short positions and ask prices for long positions

B is correct. Many practitioners believe that liquidity discounts are necessary to reflect fair value.
This has resulted in some funds having two NAVs - for trading and reporting. The fund may use
average quotes for reporting purposes but apply liquidity discounts for trading purposes.
43
• Angel investing capital is typically provided in which stage of financing?
A. Later-stage.
B. Formative-stage.
C. Mezzanine-stage.

B is correct. Formative-stage financing occurs when the company is still in the process of being
formed and encompasses several financing steps. Angel investing capital is typically raised in this
early stage of financing.
44
• An investor in a private equity fund is concerned that the general partner can receive incentive fees
in excess of the agreed-on incentive fees by making distributions over time based on profits earned
rather than making distributions only at exit from investments of the fund. Which of the following
is most likely to protect the investor from the general partner receiving excess fees?
A. A high hurdle rate
B. A claw back provision
C. A lower capital commitment

B is correct. A claw back provision requires the general partner in a private equity fund to return any
funds distributed (to the general partner) as incentive fees until the limited partners have received
back their initial investments and the contracted portion of the total profits. A high hurdle rate will
result in distributions occurring only after the fund achieves a specified return. A high hurdle rate
decreases the likelihood of, but does not prevent, excess distributions. Management fees, not
incentive fees, are based on committed capital.

45
• Until the committed capital is fully drawn down and invested, the management fee
for a private equity fund is based on:
A. invested capital.
B. committed capital.
C. assets under management.

B is correct. Until the committed capital is fully drawn down and invested, the management fee for a
private equity fund is based on committed capital, not invested capital.

46
• A private equity fund is estimating the value of a privately held company that is
financed with both debt and equity, is generating positive revenues, and has negative
EBITDA. The private equity fund is most likely able to estimate the company’s
equity value using:
A. net income multiples.
B. market value of its assets.
C. expected free cash flow to equity and cost of equity.
C is correct. The private equity fund can estimate the company’s value by discounting the expected
free cash flow to equity using the cost of equity, which is a discounted cash flow approach. A
negative EBITDA number implies negative net income, which makes net income multiples, a
comparable approach, inapplicable for valuation. In order to use an asset-based approach, the private
equity fund needs the market value of its liabilities, not just the market value of its assets.

47
CFA Website questions
• The real estate index most likely to suffer from sample selection bias is a(n):
A. repeat sales index.
B. REIT index.
C. appraisal index.

A is correct. Only properties that sell in each period and are included in the index and vary over time
which may not be representative of the whole market.

48
• The following information is available about a hedge fund:
Particulars Value
Initial fund assets $100 million
Fund assets at the end of the period (before fees) $110 million
Management fee based on assets under management 2%
Incentive fee based on the return 20%
Soft hurdle rate 8%

• No deposits to the fund or withdrawals from the fund occurred during the year. Management
fees are calculated using end-of-period valuation. Management fees and incentive fees are
calculated independently. The net-of-fees return of the investor is closest to:
A. 7.8%
B. 7.4%
C is correct.
C. 5.8%.
49
• Relative to traditional investments, alternative investments are best characterized as
having:
A. higher correlations with other asset classes.
B. unique legal and tax considerations.
C. greater liquidity.

B is correct. Alternative investments are more likely characterized as having unique legal and tax
considerations because of the broad range and complexity of the investments.

50
• For a hedge fund investor, a benefit of investing in a fund of funds is least likely the:
A. higher level of due diligence expertise.
B. multilayered fee structure.
C. ability to negotiate better redemption terms.

B is correct. Funds of funds have a multilayered fee structure that will reduce the returns to the
investor.

51
• If an investor uses derivatives to make a long investment in commodities, the return
earned on margin is best described as:
A. convenience yield.
B. collateral yield.
C. price return.

B is correct. Collateral yield is the return on cash used as margin on derivatives used to gain
commodity exposure.

52
• The return on a commodity index is likely to be different from returns on the
underlying commodities because:
A. data are subject to survivorship bias.
B. indices are constructed using futures contracts.
C. assets are not marked to market.

B is correct. Because commodity indices are constructed using commodity futures and not the
underlying commodities, there can be differences between commodity index returns and the returns
of the underlying commodities.
53
• Which of the following investments most likely provides an investor with indirect
equity exposure to real estate?
A. Real estate limited partnerships
B. Real estate investment trusts
C. Commercial mortgage-backed securities

B is correct. Real estate investment trusts (REITs) provide investors with indirect equity real estate
exposure. Real estate investment partnerships are a form of direct real estate equity investment.
Commercial mortgage-backed securities (CMBS) provide investors with indirect debt investment
opportunities in real estate.

54
• Which of the following most likely belongs in an alternative asset category?
A. A limited partnership that takes long and short positions in publicly traded equity.
B. Equity in an emerging market company that is traded over-the-counter.
C. Securitized commercial real estate debt.

A is correct. A limited partnership that takes long and short positions in publicly traded equity is one
type of hedge fund, a category of alternative assets.

55
• Which of the following infrastructure investments would most likely be easiest to
value?
A. master limited partnership holding greenfield investments.
B. master limited partnership holding brownfield investments.
C. private equity fund holding brownfield investments.

B is correct. because A master limited partnership (MLP) is publicly traded, whereas a private equity
fund is not. Therefore the MLP will have market pricing information to help with valuation. A
brownfield investment is an existing asset that likely has operational and financial history to aid in
valuation; a greenfield investment is in new construction.

56
• Investors look at many key due diligence factors when investing in hedge funds.
Which of the following factors is most likely the biggest challenge to fully assess?
A. Investment strategy and process
B. Size and longevity
C. Track record

A is correct. The investment strategy and process of a hedge fund is likely to be challenging to fully
assess because hedge funds often limit disclosure in order to maintain their competitive advantage
and to not give away information that is considered proprietary.

57
• Which of the following is most likely a private real estate investment vehicle?
A. Real estate limited partnership
B. Real estate investment trust
C. Collateralized mortgage obligation

A is correct. Real estate limited partnerships are a form of private real estate investment.

58
• Do management fees most likely get paid to the manager of a hedge fund, regardless
of the fund’s performance?
A. No, only when the fund’s net asset value exceeds the previous high-water mark
B. No, only when the fund’s gross return is positive
C. Yes

C is correct. Regardless of performance, the management fee is always paid to the fund manager.

59
• A hedge fund that implements trades based on a top-down analysis of expected
movements in economic variables most likely uses a(n):
A. macro strategy.
B. relative value strategy.
C. event-driven strategy.

A is correct. Macro strategies emphasize a top-down approach, and trades are made based on
expected movements of economic variables.

60
• The direct capitalization approach to real estate valuation most likely applies a
capitalization rate to the annual:
A. net operating income.
B. net operating income minus income taxes.
C. net operating income minus depreciation.

A is correct. Net operating income is the measure used in the direct capitalization approach. It is a
proxy for the property level operating cash flow.

61
• When the futures price of a commodity exceeds the spot price, the commodity market
is most likely in:
A. contango.
B. backwardation.
C. carry.

A is correct. When a commodity market is in contango, futures prices are higher than spot prices.
When spot prices are higher than the futures price, the market is said to be in backwardation.

62
• Which of the following hedge fund strategies is most likely categorized as an event-
driven strategy?
A. Fixed-income convertible arbitrage
B. Quantitative directional
C. Merger arbitrage

C is correct. Merger arbitrage is an event-driven strategy that involves buying the stock of the
company being acquired and selling the stock of the acquiring company when the merger and
acquisition (M&A) transaction is announced.

63
• The management fee of a private equity fund that has not yet invested all of its
committed capital is most likely based on:
A. committed capital.
B. remaining capital.
C. invested capital.

A is correct. The management fee of private equity funds is based on committed capital until the
committed capital is fully drawn down and invested. This approach is in contrast to hedge funds, for
which the management fee is based on invested capital.

64
• High Plains Capital is a hedge fund with a portfolio valued at $475,000,000 at the
beginning of the year. One year later, the value of assets under management is
$541,500,000. The hedge fund charges a 1.5% management fee based on the end-of-
year portfolio value as well as a 10% incentive fee. If the incentive fee and
management fee are calculated independently, the effective return for a hedge fund
investor is closest to:
A. 12.29%.
B. 10.89%.
C. 11.06%.
B is correct.

65
• Investors in alternative assets who seek liquidity are most likely to invest in:
A. hedge funds.
B. real estate investment trusts.
C. private equity.

B is correct. Real estate investment trusts

are publicly traded and thus provide
liquidity.

66
• A manager is compensated with a management fee based on committed capital plus
an incentive fee based on fund performance. This scenario best describes the fee
structure of a:
A. private equity fund.
B. hedge fund.
C. mutual fund.

A is correct. A private equity manager is

compensated through a management fee based on
committed capital plus an incentive fee.

67
• The real estate valuation method that uses a discounted cash flow model is best
characterized as:
A. a comparable sales approach.
B. a cost approach.
C. an income approach.

C is correct. The income approach to real estate

valuation values a property by using a discounted
cash flow model.

68
• A commodity market is in contango when futures prices are:
A. lower than the spot price
B. the same as the spot price.
C. higher than the spot price.

C is correct. When a commodity market is in

contango, futures prices are higher than the spot
price.

69
• Management fees for a private equity fund are most likely based on the:
A. fair value of assets under management.
B. drawdown of committed capital plus any undistributed capital gains.
C. total committed capital minus capital returned from investments that are exited.

C is correct. Private equity management fees are based on the

full amount of committed capital, whether drawn down or not,
minus capital that has been returned to investors from
investments that have been exited.
70
• Collectibles are least likely to provide:
A. long-term capital appreciation.
B. portfolio diversification.
C. current income.

C is correct. Collectibles do not provide current income, but

they can potentially provide long-term capital appreciation and
help further diversify a portfolio.

71
• The market approach to valuing portfolio companies in private equity firms is most
likely based on:
A. present value.
B. the value of assets minus the value of liabilities.
C. multiples.

C is correct. The market approach to valuing portfolio

companies uses multiples of different measures that are
compared with similar companies.

72
• A private equity limited partner would least likely experience which of the
following?
A. Capital calls in the partnership’s early years to fund investments.
B. A management fee based on committed capital, not invested capital.
C. Short time lags between investments in and exits from portfolio companies.

C is correct. There are likely to be long time lags between

investments in and exits from portfolio companies.

73
• In valuing underlying hedge fund positions, the most conservative approach is most
likely one that uses:
A. the average of the bid and ask prices.
B. bid prices for longs and ask prices for shorts.
C. the most recent market prices.

B is correct. A conservative and theoretically accurate approach

is to use bid prices for longs and ask prices for shorts because
these are the prices at which the positions could be closed.

74
• With regard to commodities, it is most likely true that:
A. exposure is most commonly achieved via commodity derivatives.
B. their returns are based on an income stream such as interest or dividends.
C. they are physical products so most investors prefer to trade the actual commodity.

A is correct. Commodity exposure is most commonly accessed

via commodity derivatives.

75
• An argument for investing in commodities is that they:
A. may provide a hedge against inflation.
B. are correlated negatively with stocks and bonds.
C. have low volatility.

A is correct. Given that commodity prices are positively

correlated with inflation, commodity investing may provide
higher returns when inflation is rising. In this way, commodity
investing can provide inflation protection.
76
• A disadvantage of a fund of hedge funds as compared to a large multi-strategy fund
is:
A. due diligence expertise.
B. higher management fees.
C. diversified exposure to various hedge fund strategies.

B is correct. Funds of hedge funds will add an extra layer of fees because each hedge
fund in which such fund of hedge funds invests will charge a management fee plus an
incentive fee. Such a layer of fees comes on top of the fees that the fund of hedge funds
charges investors, including management fees, to the costs for investors.
77
• The majority of private equity activity involves:
A. derivative positions.
B. leveraged buyouts.
C. investing in mortgaged-backed securities.

B is correct. The majority of private equity fund activity

involves leveraged buyouts of established profitable and
cash generative companies.

78
• A characteristic that makes a target company attractive for a leveraged buyout
transaction most likely is:
A. efficient management.
B. high leverage.
C. strong cash flow.

C is correct. Companies generating strong and sustainable cash flow are

attractive for leveraged buyout transactions because these transactions are
typically financed with significant debt where cash flow is necessary to
make interest payments on the increased debt load.
79
• An investor seeking an indirect debt investment in real estate will:
A. purchase a mortgage-backed security.
B. purchase a commercial property.
C. originate a residential mortgage.

A is correct. Mortgage-backed securities are pools of loans that are

securitized and offered to the financial markets providing indirect debt
investment opportunities in residential property.

80
• Which of the following hedge fund strategies emphasizes a top-down approach?
A. Macro
B. Equity hedge
C. Event-driven

A is correct. Macro hedge funds emphasize a “top down” approach to

identify economic trends and trade on expected movements in economic
variables.

81
• A hedge fund with $225 million of initial capital charges a management fee of 1%
and an incentive fee of 10%. The management fee is based on assets under
management at year-end, and the incentive fee is calculated independently from the
management fee. Assuming the fund earns a 15% return at year-end, total fees earned
by the hedge fund during the year are closest to:
A. $5.96 million.
B. $5.70 million.
C. $5.63 million

A is correct.

82
• An investor allocates $10 million at the beginning of the year to a hedge fund
charging a management fee of 2% and an incentive fee of 20% with a 6% (hard)
hurdle rate. At year-end the value of the investment is $11.8 million. The incentive
fee is calculated net of the management fee and the management fee is based on the
year-end value. The net-of-fees return the investor earned is closest to:
A. 13.71%.
B. 13.24%.
C. 13.93%.

A is correct.

83
• A hedge fund with $98 million of initial capital charges a management fee of 2% and
an incentive fee of 20%. The management fee is based on assets under management
at year end and the incentive fee is calculated independently from the management
fee. The fee structure has a high-water mark provision. The fund value is $112
million at the end of Year 1, $100 million at the end of Year 2, and $116 million at the
end of Year 3. The net-of-fees return earned by the fund in Year 3 is closest to:
A. 14.15%.
B. 12.33%.
C. 11.87%.

A is correct.

84
• Alternative investment funds are typically managed:
A. actively.
B. to generate positive beta return.
C. assuming that markets are efficient.

A is correct. There are many approaches to managing alternative

investment funds but typically these funds are actively managed.

85
• An investor is most likely to consider adding alternative investments to a traditional
investment portfolio because:
A. of their historically higher returns.
B. of their historically lower standard deviation of returns.
C. their inclusion is expected to reduce the portfolio’s Sharpe ratio.

A is correct. The historically higher returns to most categories of alternative investments compared
with traditional investments result in potentially higher returns to a portfolio containing alternative
investments. The less than perfect correlation with traditional investments results in portfolio risk
(standard deviation) being less than the weighted average of the standard deviations of the
investments. This has potential to increase the Sharpe ratio in spite of the historically higher
standard deviation of returns of most categories of alternative investments.
86
• The potential benefits of allocating a portion of a portfolio to alternative investments
include:
A. ease of manager selection.
B. improvement in portfolio risk–return.
C. accessible and reliable measures of risk and return.

B is correct. Adding alternative investments to a portfolio may provide diversification benefits

because of these investments’ less than perfect correlation with other assets in the portfolio. As a
result, allocating a portion of one’s funds to alternatives could potentially result in an improved risk–
return relationship. Challenges to allocating a portion of a portfolio to alternative investments
include obtaining reliable measures of risk and return as well as selecting portfolio managers for the
alternative investments.
87
• An investor seeks a current income stream as a component of total return, and desires
an investment that historically has low correlation with other asset classes. The
investment most likely to achieve the investor’s goals is:
A. timberland.
B. collectibles.
C. commodities.

A is correct. Timberland offers an income

stream based on the sale of timber products as a
component of total return and has historically
generated returns not highly correlated with
other asset classes.

88
• As the loan-to-value ratio increases for a real estate investment, risk most likely
increases for:
A. debt investors only.
B. equity investors only.
C. both debt and equity investors.

C is correct. The higher the loan-to-value ratio,

the higher leverage is for a real estate
investment, which increases the risk to both debt
and equity investors.

89
• If a commodity’s forward curve is in contango, the component of a commodities
futures return most likely to reflect this is:
A. spot prices.
B. the roll yield.
C. the collateral yield.

B is correct. Roll yield refers to the difference between the spot price of a
commodity and the price specified by its futures contract (or the difference
between two futures contracts with different expiration dates). When futures
prices are higher than the spot price, the commodity forward curve is upward
sloping, and the prices are referred to as being in contango. Contango occurs
when there is little or no convenience yield.
90
• United Capital is a hedge fund with $250 million of initial capital. United charges a
2% management fee based on assets under management at year end, and a 20%
incentive fee based on returns in excess of an 8% hurdle rate. In its first year, United
appreciates 16%. Assume management fees are calculated using end-of-period
valuation. The investor’s net return assuming the performance fee is calculated net of
the management fee is closest to:
A. 11.58%.
B. 12.54%.
C. 12.80%.

B is correct.

91
• Capricorn Fund of Funds invests GBP 100 million in each of Alpha Hedge Fund and
ABC Hedge Fund. Capricorn FOF has a “1 and 10” fee structure. Management fees
and incentive fees are calculated independently at the end of each year. After one
year, net of their respective management and incentive fees, the investment in Alpha
is valued at GBP80 million and the investment in ABC is valued at GBP140 million.
The annual return to an investor in Capricorn, net of fees assessed at the fund of
funds level, is closest to:
A. 7.9%.
B. 8.0%.
C. 8.1%.
A is correct.

92
• The following information applies to Rotunda Advisors, a hedge fund:
• $288 million in assets under management (AUM) as of prior year-end
• 2% management fee (based on year-end AUM)
• 20% incentive fee calculated:
• net of management fee
• using a 5% soft hurdle rate
• using a high-water mark (high-water mark is $357 million)

• Current year fund return is 25%

The total fee earned by Rotunda in the current year is closest to:
A. $7.20 million.
B. $20.16 million.
A is correct.
C. $21.60 million.

93
• A hedge fund has the following fee structure:
• Annual management fee based on year-end AUM 2%
• Incentive fee 20%
• Hurdle rate before incentive fee collection starts 4%
• Current high-water mark $610 million
• The fund has a value of $583.1 million at the beginning of the year. After one year, it has a
value of $642 million before fees. The net return to an investor for this year is closest to:
A. 6.72%.
B. 6.80%.
C. 7.64%. C is correct.

94
• Ash Lawn Partners, a fund of hedge funds, has the following fee structure:
• 2/20 underlying fund fees with incentive fees calculated independently
• Ash Lawn fees are calculated net of all underlying fund fees
• 1% management fee (based on year-end market value)
• 10% incentive fee calculated net of management fee
• The fund and all underlying funds have no hurdle rate or high-water mark fee conditions

In the latest year, Ash Lawn’s fund value increased from $100 million to $133 million before
deduction of management and incentive fees of the fund or underlying funds. Based on the
information provided, the total fee earned by all funds in the aggregate is closest to:
A. $11.85 million.
B. $12.75 million.
B is correct.
C. $12.87 million.
95
• An analyst wanting to assess the downside risk of an alternative investment is least
likely to use the investment’s:
A. Sortino ratio.
B. value at risk (VaR).
C. standard deviation of returns.

C is correct. Downside risk measures focus on the left side of the return distribution curve where
losses occur. The standard deviation of returns assumes that returns are normally distributed. Many
alternative investments do not exhibit close-to-normal distribution of returns, which is a crucial
assumption for the validity of a standard deviation as a comprehensive risk measure. Assuming
normal probability distributions when calculating these measures will lead to an underestimation of
downside risk for a negatively skewed distribution. Both the Sortino ratio and the value-at-risk
measure are both measures of downside risk

96
• An effective risk management process used by alternative investment funds most
likely includes:
A. in-house valuations.
B. internal custody of assets.
C. segregation of risk and investment process duties.

C is correct. Investment risk should be monitored by a chief risk

officer who is separated from the investment process. Risk factors
monitored include leverage, sector, and individual position limits as
well as counterparty risks. Independent (as opposed to in-house)
valuation of underlying positions should be performed and reviewed
on a regular basis. Third-party custody of assets can help reduce the
chance of fraud.

97