CAIA Level 2 Quiz 90

A key-person provision in a side letter allows investors to redeem their investment with more flexible terms if a designated key individual departs the hedge fund. This is crucial because the investor can then avoid having their capital tied up in a fund where the primary investment decision-maker is no longer present, and they haven’t had the opportunity to assess the replacement. While side letters can raise fairness concerns among other investors, this specific provision directly addresses the risk associated with the departure of a critical individual.

The core-satellite portfolio approach in private equity involves allocating capital to a ‘core’ portfolio of established, lower-risk funds and a ‘satellite’ portfolio of newer, higher-risk, or experimental funds. The satellite portfolio is designed to capture opportunities arising from market shifts or emerging trends, acting as a form of real option. The decision to allocate more to the satellite portfolio (exploration) versus the core portfolio (exploitation) is influenced by several factors. A longer time horizon allows for greater exploration because the potential for future growth and the value of the ‘real option’ increase over time. Similarly, greater available resources (a larger reserve buffer) permit a higher degree of exploration, as the investor can absorb potential losses from the satellite investments. Finally, anticipating a more volatile or disruptive market environment necessitates spreading investments across more options (higher allocation to satellite) to capture potential upside from unforeseen changes, whereas a stable environment favors a more concentrated, exploitation-focused core strategy.

Operational due diligence for a convertible arbitrage strategy requires a thorough examination of the fund’s valuation policies. A key aspect is understanding how the portfolio is valued, particularly for less liquid or complex instruments. While mark-to-market is generally preferred for its transparency and reliance on observable prices, many strategies, including convertible arbitrage, may necessitate mark-to-model valuations for certain assets. The critical factor is the robustness of the model and the procedures surrounding its use. A strong due diligence process would scrutinize the consistency between pricing and hedging models, the frequency of model upgrades, and the handling of discrepancies between model outputs and market quotes. The use of multiple independent broker quotes and a documented policy for resolving differences are essential. Furthermore, understanding the proportion of the portfolio valued using each method (mark-to-market vs. mark-to-model) and the rationale behind any discretionary marks is crucial for assessing valuation risk.

The core of unsmoothing involves reversing the effects of autocorrelation, which artificially dampens volatility. Equation 16.9 provides the direct method for this reversal when a first-order autocorrelation is assumed. It isolates the true return by adjusting the reported return for the lagged reported return, weighted by the autocorrelation coefficient. Options B, C, and D represent incorrect applications or misunderstandings of the unsmoothing process. Option B incorrectly applies the autocorrelation coefficient to the current period’s reported return without accounting for the lagged return. Option C attempts to adjust the reported return by adding the lagged term, which is the opposite of the required subtraction. Option D misinterprets the role of the autocorrelation coefficient, suggesting it should be subtracted directly from the reported return without considering the lagged component or the denominator.

The question probes the understanding of how fundamental equity hedge fund managers might exploit market inefficiencies. The provided text highlights that smaller capitalization stocks and value stocks have historically outperformed larger and growth stocks, respectively. This outperformance is attributed to potential informational inefficiencies in these less-monitored segments of the market. Fundamental managers can leverage this by taking long positions in undervalued small-cap value stocks and short positions in overvalued large-cap growth stocks, thereby capturing the premium associated with these factors. The other options represent less direct or incorrect explanations for potential outperformance. Option B describes a general market efficiency, not a specific strategy. Option C refers to a different type of strategy (activist investing) which, while potentially profitable, isn’t the primary mechanism described for exploiting size and value factor inefficiencies. Option D describes a passive approach, which is contrary to the active fundamental analysis employed by these funds.

Latency arbitrage, as described, exploits temporary price discrepancies arising from differences in the speed at which various exchanges update their quotes. A successful latency arbitrageur, often a high-frequency trader (HFT), capitalizes on these timing differences by simultaneously executing trades on exchanges with faster quote refreshes and those with slower ones. For instance, if a security’s price increases on a rapidly updating exchange, the arbitrageur would sell on that exchange and buy on a slower one, aiming to profit when the slower exchange eventually reflects the updated price. This strategy relies on technological infrastructure and speed, not on fundamental analysis or informational advantage about the security itself. The core principle is profiting from the ‘stale’ pricing on slower systems until they synchronize.

Hedge fund replication products aim to capture the underlying sources of return and risk, often referred to as ‘betas,’ that are characteristic of specific hedge fund strategies. Alternative betas are those return drivers not readily available through traditional asset classes or are intrinsically bundled with other risks in traditional investments. For instance, while equities have exposure to volatility, this is typically integrated with pure equity risk. Other examples of alternative betas include currency exposures, momentum effects, and risks embedded in structured products. The goal is to isolate and replicate these specific risk premia, which may not be easily accessible or are obscured within traditional investment vehicles.

The passage highlights that mean-variance optimization (MVO) can be problematic for hedge fund strategies due to non-normal return distributions, specifically negative skewness and excess kurtosis. While MVO aims to minimize risk (standard deviation) and maximize return, it assumes normal distribution. When returns exhibit skewness (asymmetry) and kurtosis (fat tails), MVO’s efficiency estimates can be misleading. The text suggests that incorporating factors like the VIX or optimizing for zero skew and excess kurtosis are methods to address these distributional issues. Therefore, the primary limitation of MVO in this context is its reliance on the assumption of normally distributed returns, which is often violated by hedge fund strategies.

The question tests the understanding of how combining factors with low correlations can improve a portfolio’s risk-adjusted return. The Fama-French three-factor model (Mkt-RF, SMB, HML) is introduced, and the concept of an equally weighted (EW) portfolio combining these factors is presented. Exhibit 37.3 shows that the EW portfolio has a higher annualized return divided by annualized standard deviation (Ann.Ret/Ann.Std) of 0.61 compared to the individual factors (Mkt-RF: 0.28, SMB: 0.26, HML: 0.48). This improvement is attributed to the low correlations between the factors, which allow for diversification benefits. Therefore, a quantitative equity strategy that combines these factors in a market-neutral, equally weighted manner would aim to capture these diversification benefits to enhance its risk-adjusted performance.

This question tests the understanding of how global macro managers might position themselves in relation to currency volatility. The provided text states that managers can profit from long options positions in times of rising volatility and from short options positions during times of declining volatility. It also mentions that short options positions can benefit from time decay during stable volatility. Therefore, a manager expecting stable or declining volatility would favor short options positions to capture time decay or benefit from the decrease in implied volatility.

The Limited Partnership Agreement (LPA) is the foundational document governing a private equity fund. It meticulously outlines the rights, responsibilities, and economic arrangements between the General Partner (GP) and the Limited Partners (LPs). While the LPA addresses various aspects of fund operation, including investment strategy, key-person provisions, and termination clauses, its primary function is to establish the legal and operational framework. The Private Placement Memorandum (PPM) serves as a marketing and disclosure document, detailing the investment proposal, but it is the LPA that legally binds the parties and defines the fund’s structure and terms. The subscription agreement formalizes the investor’s commitment and addresses securities law exemptions, but it is a component within the broader LPA framework. Therefore, the LPA is the most comprehensive document defining the fund’s structure and terms.

The core challenge in valuing Over-the-Counter (OTC) commodity derivatives lies in the lack of readily available, transparent pricing data. Unlike exchange-traded futures, OTC contracts are negotiated privately, making it difficult to establish a real-time market price. Relying solely on exchange-traded data as a proxy for OTC valuations can lead to significant inaccuracies in determining the Net Asset Value (NAV) of a commodity portfolio. This is because the underlying forward curves, which are crucial for pricing these derivatives, may not be traded on exchanges and can differ substantially from exchange-derived data, especially when considering factors like seasonal patterns and volume weighting. Therefore, access to independent, accurate forward curves is essential for a risk manager or investor to correctly mark positions and understand the true market value.

The provided text emphasizes that due diligence in private equity fund selection is primarily an information-gathering and evaluation process, not a decision-making tool in itself. While it helps to filter out inferior funds, the final investment decision should incorporate the due diligence findings alongside the overall portfolio composition and strategic fit. Therefore, a fund manager’s decision to commit capital should consider the fund’s quality as evaluated through due diligence, but also how it aligns with the investor’s broader investment program and existing portfolio. Options B, C, and D represent either an over-reliance on due diligence as the sole decision driver, a misunderstanding of its purpose, or an incomplete consideration of the investment decision process.

The provided text highlights that reported volatilities for CTAs can be misleading because they are often calculated using a rolling window that doesn’t account for emerging trends. When a price breaks out and establishes a new trend, the estimated unconditional volatility increases. However, if an observer is unaware of this trend, the calculated volatility will differ from the true volatility (which is zero in a perfectly predictable trend). This discrepancy can lead to the misinterpretation that CTAs are ‘long volatility’ when, in reality, their strategies are designed to profit from these predictable price movements. The core issue is the mismatch between estimated volatility and the underlying price behavior.

The question probes the understanding of how intellectual property (IP) is valued and invested in, specifically differentiating between IP that is newly created and IP that is established. Newly created IP, such as exploratory research or pending patents, carries significant uncertainty regarding its future value and success, much like venture capital investments. While a small proportion may yield substantial returns, a larger portion may not even recoup initial costs. Mature IP, conversely, has demonstrated utility and a more predictable income stream through licensing or royalties, leading to more certain valuations and market pricing that reflects its associated risks. Therefore, the scenario of a film in its initial production phase, with uncertain market reception and revenue potential, aligns with the characteristics of newly created IP.

The question asks to identify the manager with the highest risk-adjusted return, which is best represented by the Sharpe ratio. Manager C has a Sharpe ratio of 0.63, which is the highest among the three hypothetical managers (Manager A: 0.40, Manager B: 0.58). While Manager B has a higher mean return than Manager A, Manager C surpasses both in terms of risk-adjusted performance. 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, both lower than Manager C.

The endowment model, as exemplified by Yale’s approach under David Swensen, prioritizes equity exposure for long-term growth. Fixed income is viewed primarily as a tool for liquidity and a ‘tail hedge’ to mitigate significant downturns. The model deliberately avoids corporate bonds due to a perceived principal-agent conflict, where management’s decisions might favor stockholders over bondholders, potentially leading to reduced liquidity and value during market stress. Sovereign bonds are considered for their liquidity and crisis hedging properties, but foreign bonds are excluded due to the added complexity of currency risk and uncertain performance during financial crises, which could undermine the intended stabilizing effect of the fixed-income allocation.

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.

The core challenge in applying modern portfolio management techniques like mean-variance optimization to real estate stems from the difficulty in accurately estimating its historical volatility and correlation with other asset classes. This ‘risk measurement risk’ arises from the inherent illiquidity, infrequent valuation, and unique market dynamics of real estate, which make it challenging to derive reliable statistical inputs. Consequently, the outputs of optimization models based on these inputs become less dependable, requiring a more qualitative and experience-based approach to portfolio allocation.

The question tests the understanding of overcommitment strategies in private equity, specifically how an investor might aim to achieve a target investment level even when their readily available resources are insufficient. An overcommitment strategy involves committing more capital than currently available resources, with the expectation that future capital calls will be met by either existing liquid assets or anticipated future inflows. Option A correctly identifies this by stating the investor commits more than available resources to reach a target exposure, relying on future capital availability. Option B is incorrect because overcommitment is about exceeding current resources, not simply diversifying across different fund vintages. Option C is incorrect as overcommitment is a strategy to meet a target, not a method to avoid capital calls. Option D is incorrect because while liquidity management is crucial, overcommitment itself is a strategy that necessitates careful liquidity planning, not a direct liquidity management tool in the sense of managing existing cash flows.

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_domestic) = (1 + r_foreign) * (E[S_{t+1}] / S_t), where r is the interest rate, S is the spot exchange rate, E[S_{t+1}] is the expected future spot exchange rate, and t denotes the current time. In this scenario, the domestic currency is the USD (r_domestic = 2%) and the foreign currency is the JPY (r_foreign = 1%). The current spot rate (S_t) is 0.0125 USD/JPY. To find the expected future spot rate (E[S_{t+1}]), we rearrange the UIRP formula: E[S_{t+1}] = S_t * (1 + r_domestic) / (1 + r_foreign). Plugging in the values: E[S_{t+1}] = 0.0125 * (1 + 0.02) / (1 + 0.01) = 0.0125 * (1.02 / 1.01) = 0.0125 * 1.00990099… \approx 0.01262376. This indicates that the JPY is expected to appreciate against the USD, which is consistent with the higher interest rate in the US, as the higher-yielding currency is expected to depreciate to offset the interest rate differential.

The Chief Compliance Officer (CCO) is tasked with ensuring that an investment adviser’s policies and procedures are not only designed but also effectively implemented and tested. This involves a proactive approach to identifying potential compliance risks and then verifying that the established controls are functioning as intended. Regular testing and reporting are crucial for demonstrating the robustness of the compliance program to senior management and regulators, and for identifying areas that may require refinement. While reviewing marketing materials and ensuring accurate disclosures are vital duties, they are specific applications of the broader compliance framework. Identifying conflicts of interest is a foundational step in policy design, but the CCO’s role extends to ongoing validation of the effectiveness of the measures taken to address those conflicts.

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 losses directly or rely on the recovery of assets from the bankrupt estate, which can be a lengthy and uncertain process. The question tests the understanding of the regulatory framework and investor protections specific to the managed futures industry compared to other financial markets.

The question tests the understanding of the overcommitment ratio in private equity, specifically how it relates to the actual capital called versus the committed capital. An overcommitment ratio of 140% implies that for every 5% of a fund allocated in a strategic asset allocation, an investor is willing to commit 7% of that fund’s capital. This is based on the empirical observation that, on average, not all committed capital is called. The provided text suggests that an overcommitment level of around 140% is feasible if, on average, only 70% of commitments are actually called (7% committed / 5% allocated = 1.4 or 140%). This strategy aims to maximize the deployment of capital into private equity while managing liquidity risk through diversification and accurate cash flow projections.

The endowment model, as described, emphasizes a significant allocation to alternative investments to achieve long-term return targets that outpace inflation and cover spending needs. While mimicking asset allocations is a starting point, the text explicitly states that simply replicating the portfolio structure of successful endowments does not guarantee similar performance. This is because top endowments have historically generated substantial value through superior manager selection and astute market timing, factors not directly captured by asset allocation alone. Therefore, understanding these qualitative drivers is crucial for effectively emulating the endowment model’s success.

The question tests the understanding of how cap rates are used in real estate valuation and risk assessment, specifically in the context of different property investment styles. Core properties are generally considered lower risk and thus command lower cap rates (higher valuations for a given NOI). Value-added properties, by definition, involve some level of repositioning or improvement, introducing more risk and thus requiring a higher cap rate. Opportunistic properties carry the highest risk, often involving ground-up development or distressed assets, necessitating the highest cap rates. Therefore, an investor demanding a higher cap rate for a value-added property compared to a core property reflects the increased risk associated with the value-added strategy.

Defined benefit (DB) plans are characterized by the employer assuming the investment risk. The employer guarantees a specific income stream to the retiree, calculated based on a predetermined formula (often related to salary and years of service). This means that if the pension fund’s investments underperform, the employer is obligated to make up the shortfall to ensure the promised benefit is paid. In contrast, defined contribution (DC) plans shift the investment risk to the employee, where the retirement income depends on the total contributions and the investment performance of the individual’s account. Governmental social security plans are typically funded by taxpayers and managed by the government, with benefits often determined by legislation rather than specific investment outcomes.

The core issue highlighted in the provided text is the significant difference in volatility observed between market-based real estate returns (like REITs) and appraisal-based returns (like NCREIF NPI). The text explores several potential explanations for this discrepancy. While leverage can contribute to higher volatility in market-based indices, it’s noted that leverage differentials alone cannot fully account for the magnitude of the difference. The text also discusses the possibility of different underlying assets, but suggests that many REITs hold similar institutional-quality properties to those in appraisal-based indices. The most compelling explanations offered are the lower accuracy of smoothed appraisals compared to market prices, and the impact of liquidity-induced volatility from equity market trading. The latter suggests that REIT prices can be influenced by broader market sentiment and liquidity shifts, which are not directly tied to the underlying real estate’s fundamental value. Therefore, the greater dispersion in market-based returns is likely a combination of less accurate appraisals and the influence of equity market dynamics on REIT pricing.

The Interim Internal Rate of Return (IIRR) calculation for private equity funds incorporates the Net Asset Value (NAV) as the final cash flow. This approach, while common for published performance statistics before a fund’s termination, inherently assumes that the future cash flows are solely derived from the current portfolio’s NAV. However, a significant portion of a fund’s expected future performance also stems from new investments funded by undrawn commitments. By omitting these future investment cash flows (CFNEWt), the IIRR calculation can incentivize short-term portfolio management decisions, as it doesn’t fully account for the long-term growth potential from new ventures. Therefore, a comprehensive assessment of a fund’s expected investment performance requires considering all three components of the IIRR: past cash flows, current portfolio value (NAV), and anticipated cash flows from future investments.

The Chief Compliance Officer (CCO) is tasked with establishing a culture of compliance within an investment advisory firm. This involves not only ensuring adherence to policies and procedures but also actively testing their effectiveness and reporting findings to senior management. The CCO’s role necessitates objectivity and detachment from the day-to-day operations to maintain impartiality. Therefore, a CCO’s primary responsibility is to oversee and enforce the firm’s compliance program, which includes testing its efficacy and reporting on identified issues. While reviewing marketing materials and identifying conflicts of interest are crucial duties, they are components of the broader responsibility of administering and testing the compliance program.