CAIA Level 2 Quiz 35

The core finding of Gorton and Rouwenhorst (2006) was that an equally weighted index of commodity futures exhibited a negative correlation with traditional asset classes like equities and bonds, while showing a positive correlation with inflation. This diversification benefit, coupled with a similar return and Sharpe ratio to equities, made commodities attractive for pension plans seeking to match asset returns with liabilities. The study also highlighted that direct equity investments in commodity-producing firms did not offer the same diversification benefits, as these stocks were more correlated with the broader stock market than with the underlying commodities themselves. Therefore, the primary driver for including commodities in asset allocation, based on this research, is their potential to reduce overall portfolio risk through diversification and their inflation-hedging properties.

The core challenge in managing private equity liquidity stems from the inherent unpredictability of capital calls and distributions. General partners (GPs) control the timing of drawdowns, which are contingent on identifying investment opportunities and covering fees, not on the limited partner’s (LP’s) preferred schedule. Similarly, exit timing and size are highly uncertain, influenced by company growth, value-added by the GP, and prevailing market conditions. This lack of control over the timing and size of cash flows makes precise portfolio allocation difficult. Therefore, investors must build their private equity exposure over multiple vintage years and maintain an allocation range rather than a fixed target to manage this inherent illiquidity.

The delegated approach to accessing hedge funds involves investing through a Fund of Funds (FoF). FoFs provide several key services to investors, including portfolio construction (deciding allocations to different strategies and managers based on risk, return, and correlation), manager selection (identifying and choosing suitable hedge fund managers), risk management and monitoring (overseeing underlying fund performance and risk exposures), and due diligence (evaluating the operational and management quality of hedge funds). While direct investment offers cost savings and greater control, the delegated approach is designed to simplify the complex process of hedge fund investing for those who may lack the resources or expertise for direct access. The indexed approach, on the other hand, focuses on replicating a hedge fund index, which is a different strategy altogether.

The DJUBSCI, unlike the S&P GSCI, skips every other expiration for commodities traded on a monthly schedule. This strategy results in a longer average maturity for energy and metal commodities compared to agricultural commodities, which have the same average maturity as the S&P GSCI. This difference in maturity management is a key distinguishing feature of the DJUBSCI’s methodology for certain commodity types.

The CAIA syllabus emphasizes that when hedge fund managers present performance data in communications, they must provide context to avoid misleading investors. This includes disclosing the impact of material market or economic conditions on the reported results. For instance, reporting a 10% increase in an equity account without mentioning that the broader market rose by 40% during the same period would be considered misleading. Therefore, the correct response must include this crucial disclosure requirement.

The question probes the understanding of how transaction costs impact the net returns of art investments. The provided text highlights that hammer prices do not include auction house commissions, which can be substantial (up to 15% for both buyer and seller). When considering a typical round-trip transaction cost of 25%, it implies that a significant portion of the appreciation must first offset these costs before any net return is realized. Therefore, a longer holding period is generally required to overcome these initial expenses and achieve a positive real return.

The core-satellite portfolio approach in private equity involves allocating capital to a ‘core’ portfolio of established, lower-risk strategies and a ‘satellite’ portfolio for more experimental, higher-risk opportunities. The balance between these two components is influenced by several factors. A longer time horizon allows for greater allocation to the satellite portfolio, as it provides more time for these ‘real options’ to mature and potentially yield significant returns. Ample available resources (a larger reserve buffer) also permit a higher degree of exploration within the satellite portfolio. Furthermore, an anticipated volatile or disruptive market environment necessitates a broader spread of options, thus favoring a larger satellite allocation to capture potential upside from unforeseen shifts. Conversely, a stable market environment allows for a reduced satellite allocation, focusing more on the core portfolio’s predictable returns. Therefore, the time horizon, available resources, and anticipated market volatility are key determinants in balancing core and satellite allocations.

The question asks to identify the manager with the most favorable risk-adjusted return based on the provided exhibit. The Sharpe ratio is the standard metric for risk-adjusted return, calculated as (Return – Risk-Free Rate) / Standard Deviation. A higher Sharpe ratio indicates a better risk-adjusted performance. Examining Exhibit 32.6, Manager C has the highest Sharpe ratio of 0.63, which is superior to Manager A’s 0.40 and Manager B’s 0.58. The MSCI World Equity Index has a Sharpe ratio of 0.16, and the Barclays Global Aggregate Bond Index has a Sharpe ratio of 0.55. Therefore, Manager C demonstrates the best risk-adjusted performance among the managed futures managers.

The core issue with appraisal-based real estate indices like the NCREIF NPI is that appraisals are not updated as frequently as market prices, leading to a smoothing effect. This smoothing means that the reported returns in a given period are influenced not only by the true underlying return in that period but also by the smoothed return from the previous period. This creates a positive autocorrelation in the reported return series. The REIT index, based on market prices, is used as a proxy for true returns, which are expected to have little to no autocorrelation. Therefore, when comparing the two, the NCREIF NPI’s returns would exhibit a positive correlation with its own lagged returns, reflecting the smoothing effect, while the REIT index’s returns would not show this characteristic.

The DJUBSCI, unlike the S&P GSCI, skips every other expiration for commodities traded on a monthly schedule. This strategy results in a longer average maturity for energy and metal commodities compared to agricultural commodities, which have the same average maturity as the S&P GSCI. This difference in maturity management is a key distinguishing feature of the DJUBSCI’s methodology.

When an investor decides to allocate capital to Commodity Trading Advisors (CTAs), a key strategic decision involves the number of CTAs to include in the portfolio. Investing in a single CTA offers simplicity and can be aligned with a broad trend-following benchmark if a large, diversified manager is chosen. However, this approach concentrates risk on a single entity and potentially a limited set of trading strategies. To mitigate these risks and achieve diversification benefits, a portfolio approach is generally recommended. This involves selecting multiple CTAs, which spreads risk across different managers, strategies, and potentially market exposures, thereby enhancing the overall robustness of the managed futures allocation.

The MF Global bankruptcy highlighted a critical difference in investor protection between futures markets and traditional securities markets. In the futures industry, customer funds are typically held in segregated accounts, but there is no overarching government-backed insurance scheme like SIPC (Securities Investor Protection Corporation) that protects investors in securities markets. SIPC provides insurance for cash and securities held by brokerage firms, up to certain limits, in the event of firm insolvency. Futures investors, however, lack this direct protection, meaning that if an FCM fails and customer funds are mismanaged or lost, the investors bear the direct risk of those losses. The text explicitly states that investors in traditional stocks and bonds do not face such a risk in the United States because SIPC insures their accounts, and there is no similar protection for futures contracts.

The bottom-up approach to private equity portfolio design prioritizes the selection of individual fund managers based on their perceived ability to generate alpha, meaning returns uncorrelated with the broader market. This strategy emphasizes rigorous research and due diligence to identify managers with a proven track record and strong investment acumen. While diversification across multiple funds is a component, the core tenet is concentrating capital in what are believed to be the highest-performing funds, driven by manager quality. Macroeconomic analysis or broad market trends are secondary to the manager-specific assessment in this methodology.

The question tests the understanding of the typical lifecycle and capital deployment strategy of a private equity fund. Private equity funds are structured as limited partnerships with a finite life, usually 7-10 years, often with extensions. Commitments are drawn down as needed for investments and expenses, not held as large pools of uninvested capital. The investment period, typically the first 3-5 years, is when new investments are made. Following this, the focus shifts to managing and exiting existing portfolio companies during the divestment period. Distributions are made as investments are realized. Therefore, the statement that funds maintain substantial uninvested capital throughout their life is incorrect, as capital is called and invested as opportunities arise, and then distributed upon successful exits.

The FTSE National Association of Real Estate Investment Trusts (NAREIT) U.S. Real Estate Index Series categorizes REITs based on their underlying property holdings. Equity REITs, which own physical real estate, are further subdivided by property sector. The question asks to identify the sector that is NOT a primary subdivision of equity REITs within this index series. While timberland is a recognized real estate sector, it is typically classified as a subsector within the broader industrial/office or diversified categories, or sometimes as its own distinct category depending on the specific index construction, but not as a primary, standalone sector like industrial/office, retail, or residential in the initial broad classification of equity REITs as described in the provided text. The text explicitly lists industrial/office, retail, residential, diversified, lodging/resorts, health care, self-storage, and timber as subdivisions, but the question implies a primary classification. Timberland’s inclusion as a primary sector is less common in the initial broad categorization compared to the others listed.

Operational due diligence for hedge funds involves a thorough examination of the fund’s internal processes and controls to ensure operational efficiency, risk management, and compliance. When assessing a long/short equity manager’s short selling strategy, a key area of focus is the management of borrowed shares. Understanding whether the manager utilizes a single prime broker or multiple sources for borrowing, and their capability to source difficult-to-borrow securities, is crucial. This directly impacts the manager’s ability to execute and maintain short positions effectively and manage associated risks, such as settlement risk and the potential for unlimited losses if short positions are not managed properly. The question probes the understanding of how the operational infrastructure supports the investment strategy, specifically concerning the sourcing of securities for short sales.

The top-down approach to private equity portfolio design prioritizes macroeconomic analysis and strategic asset allocation. This involves assessing factors like political stability, economic conditions, currency risks, and the overall receptiveness of a market to private equity. The goal is to align the portfolio with broad market trends and objectives, rather than focusing on individual fund characteristics initially. Commitment planning, cash flow projections, and stress testing are subsequent steps to refine the allocation based on the strategic framework. The bottom-up approach, conversely, emphasizes identifying and selecting individual high-quality funds, which can lead to an unbalanced portfolio if not managed with a broader strategic view.

The core of effective monitoring in private equity, as highlighted in the provided text, lies in the Limited Partner’s (LP) ability to gather and analyze information. While networking with other LPs is valuable for market intelligence and deal access, and co-investment strategies necessitate screening opportunities, the fundamental mechanism for understanding fund performance and identifying potential issues is through the information provided by the General Partner (GP). This information, whether quantitative or qualitative, is crucial for assessing the fund’s progress and making informed decisions. The text emphasizes that the private equity sector’s ‘private’ nature limits transparency, making the LP’s proactive information gathering and analysis paramount. Therefore, optimizing the management of commitments through precise cash flow forecasting, which directly stems from reliable information, is a key outcome of effective monitoring.

The provided text highlights that periods of restrictive monetary policy, characterized by rising interest rates, are associated with higher commodity returns. This is attributed to several factors: higher inflation expectations leading to increased demand for commodities as inflation hedges, and higher real interest rates increasing the opportunity cost of holding commodities, which can lead to a temporary reduction in demand and subsequent price appreciation as commodities become undervalued. The research cited suggests that this effect is particularly pronounced for energy and industrial metals. Conversely, expansive monetary policy (lower interest rates) is linked to lower commodity returns.

Alfred Winslow Jones is widely recognized as the pioneer of the hedge fund industry and, specifically, the long/short equity strategy. His firm, A.W. Jones & Co., established in 1949, is credited with initiating this investment approach. While the strategy and the industry did not achieve immediate widespread adoption, Jones’s innovation laid the groundwork for future developments. The question tests the historical origin of the long/short equity hedge fund strategy, a foundational concept in understanding hedge fund evolution.

Uncovered Interest Rate Parity (UIRP) posits that the difference in interest rates between two countries should be equal to the expected change in the exchange rate between their currencies. The formula for UIRP is: (1 + r_FCU) * E[S_{t+1}] / S_t = (1 + r_DCU), where r_FCU is the foreign currency interest rate, r_DCU is the domestic currency interest rate, S_t is the current spot exchange rate, and E[S_{t+1}] is the expected future spot exchange rate. In this scenario, the domestic currency is the Japanese Yen (JPY) and the foreign currency is the US Dollar (USD). We are given r_DCU = 1% (0.01), r_FCU = 2% (0.02), and S_t = 0.0125 JPY/USD. To find the expected future spot rate E[S_{t+1}], we rearrange the UIRP formula: E[S_{t+1}] = S_t * (1 + r_DCU) / (1 + r_FCU). Plugging in the values: E[S_{t+1}] = 0.0125 * (1 + 0.01) / (1 + 0.02) = 0.0125 * 1.01 / 1.02 = 0.01237745. This indicates that the Yen is expected to depreciate against the US Dollar, which is consistent with the higher interest rate in the US.

The MF Global bankruptcy highlighted a critical difference in investor protection between futures markets and traditional securities markets. In the futures industry, customer funds are required to be segregated, meaning they should be held separately from the FCM’s own assets. However, unlike investors in securities markets who are protected by SIPC insurance, futures investors lack a similar government-backed insurance mechanism. This means that in the event of an FCM’s insolvency, customer losses are not covered by an external insurance fund, and they may have to absorb those losses directly or through recovery efforts from the bankrupt estate. The question tests the understanding of the regulatory framework and investor protections specific to the managed futures industry compared to other financial markets.

Convertible arbitrage strategies aim to profit from mispricings in convertible bonds. A common approach involves shorting the underlying stock and buying the convertible bond. This strategy is sensitive to changes in interest rates, which affect the bond’s value. Rho, in the context of the Black-Scholes model, measures the sensitivity of an option’s price to a change in the risk-free interest rate. For a convertible bond, which has embedded option-like features (the conversion option), changes in interest rates will impact its value. Specifically, an increase in interest rates generally decreases the value of a fixed-income instrument like the bond component of a convertible, while it can also affect the value of the embedded equity option. Therefore, understanding the rho of the convertible bond is crucial for managing interest rate risk in a convertible arbitrage strategy.

When an investor decides to allocate capital to Commodity Trading Advisors (CTAs), a critical decision involves the structure of this investment. Investing in a single CTA, while simpler, concentrates risk on one manager, potentially limiting the trading strategies employed and increasing exposure to a single entity. To mitigate these risks and achieve diversification, a portfolio approach is generally recommended. A multi-CTA fund offers a cost-effective initial step towards diversification. However, as the investment size grows, the investor may consider assembling an in-house team to manage a portfolio of individual CTAs. This transition becomes cost-effective when the management fees saved from avoiding a multi-CTA fund, combined with the costs of building an internal team and the minimum investment requirements of individual CTAs, justify the operational overhead. A portfolio of at least six CTAs, with minimum investments of $5 million each, suggests a threshold of around $30 million for cost-effectiveness in building an in-house diversified CTA portfolio, considering the management fees involved.

The question probes the understanding of how investor participation, particularly from financial entities like hedge funds and swap dealers, can influence commodity futures markets. The provided text highlights that increased financialization can lead to greater price efficiency and tighter co-integration between near-month and longer-maturity futures. This is because these participants often engage in strategies that involve rolling contracts, which are sensitive to the term structure of futures. Therefore, their presence can reduce the arbitrage opportunities that might arise from discrepancies in the futures curve, making the market more efficient and the relationships between different contract maturities more pronounced.

This question assesses the understanding of how non-zero-sum dynamics in futures markets can contribute to returns for trend-following strategies. The core argument presented is that participants with offsetting positions in spot markets may tolerate losses in futures, creating a potential profit source for those who can identify and capitalize on trends. This contrasts with a purely zero-sum view where one party’s gain is precisely another’s loss. Behavioral aspects, such as investor irrationality leading to price trends, are also cited as a source of return, which systematic traders can exploit. Therefore, the ability to profit from market participants willing to accept futures losses due to other market exposures is a key element.

The question tests the understanding of the liquidity premium in real estate investments. Private real estate is inherently illiquid due to factors like the uniqueness of properties, high transaction costs (which can approach 10% of the property value), and the lengthy sales process involving marketing, due diligence, and negotiation. This illiquidity necessitates a higher expected return to compensate investors for the risks and inconveniences associated with holding such assets. This additional return is known as the liquidity premium. Therefore, investors who are less concerned about immediate access to their capital should consider allocating more to illiquid assets like private real estate to potentially benefit from this premium.

The question probes the understanding of how different replication methodologies aim to capture hedge fund returns. A factor-based approach seeks to replicate returns by identifying and investing in liquid securities that exhibit similar systematic risk exposures (betas) to the target hedge fund strategy. This acknowledges that a significant portion of hedge fund returns can be attributed to common risk factors. The payoff distribution approach, conversely, focuses on replicating the observed distribution of returns, often through dynamic trading of underlying instruments. Algorithmic approaches use systematic rules to trade. Therefore, a factor-based replication strategy would most directly aim to capture the systematic risk exposures that drive a hedge fund’s performance.

The theory of normal backwardation, as proposed by Keynes, suggests that futures prices should generally be lower than the expected future spot price. This difference, known as the risk premium, incentivizes speculators to take long positions, thereby providing a hedging mechanism for producers who are typically short. The risk premium compensates speculators for bearing the price risk. In the given scenario, the futures price ($95) is lower than the expected future spot price ($105), indicating normal backwardation. The risk premium is the difference between these two ($105 – $95 = $10). A speculator taking a long position expects to profit if the actual spot price at maturity is not lower than the expected spot price by more than this risk premium. If the actual spot price is $100, the profit is $100 – $95 = $5. This profit is composed of the risk premium ($10) plus the difference between the actual spot price and the expected spot price ($100 – $105 = -$5), resulting in $10 + (-$5) = $5. Therefore, the ex post profit for the speculator is indeed $5.

When an investor decides to allocate a significant portion of their capital to Commodity Trading Advisors (CTAs), the choice between a multi-CTA fund and an in-house construction team hinges on several factors. A multi-CTA fund offers the benefit of professional management and potentially broader diversification across various CTA strategies, but it typically comes with an additional layer of fees. An in-house team allows for greater control and customization but requires significant internal expertise and resources for selection, monitoring, and portfolio construction. A managed account platform, however, is specifically designed for substantial allocations, providing enhanced transparency into the underlying CTA strategies, greater control over portfolio construction and risk management, and the ability to customize the investment program to meet specific investor objectives. This level of detail and control is generally not available through a multi-CTA fund structure.