CAIA Level 2 Quiz 18

Operational due diligence for hedge funds involves a thorough examination of the fund’s back-office operations to ensure efficiency, accuracy, and robustness. A key component of this is assessing the fund’s relationship with its administrator. A well-established and reputable administrator provides a layer of confidence to investors regarding the accuracy of Net Asset Value (NAV) calculations, proper expense management, and the overall integrity of financial reporting. Conversely, a less-known or smaller administrator necessitates a more rigorous review of their internal controls, accounting procedures, and error monitoring to mitigate potential operational risks.

The scenario describes a situation where a private equity fund’s investment strategy is failing, and the general partner (GP) is not proposing viable alternatives. In such cases, Limited Partners (LPs) have several avenues for recourse. The most direct and impactful action, short of legal proceedings, is to withhold future capital commitments. This action is particularly feared by GPs as it signals a lack of confidence to the broader market, potentially jeopardizing future fundraising efforts and damaging the GP’s reputation. While renegotiating fees or seeking early exit through secondary markets are also options, refusing follow-on commitments directly addresses the GP’s ability to continue operations and raise new funds, making it the most potent tool for influencing the GP’s behavior or signaling dissatisfaction.

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.

Operational due diligence for hedge funds involves a thorough examination of the fund’s back-office operations to ensure efficiency, accuracy, and robustness. A key component of this is assessing the fund’s relationship with its administrator. A well-established and reputable administrator provides a layer of confidence to investors by demonstrating that critical functions like NAV calculation, expense management, trade settlement, and dividend distribution are handled with a high degree of accuracy and control. Conversely, a less-known or smaller administrator necessitates a more rigorous vetting process by investors to identify potential weaknesses in accounting controls and procedures, which could lead to errors in NAV calculations or other operational failures.

Closed-end real estate funds, unlike open-end funds, do not allow for the creation or redemption of shares directly with the fund. This structural difference prevents arbitrageurs from continuously aligning the fund’s market price with its Net Asset Value (NAV). Consequently, closed-end funds, including those focused on real estate, are prone to trading at significant premiums or discounts to their NAVs, particularly when the underlying assets’ valuations are not readily observable or are subject to market volatility. This divergence from NAV is a key characteristic that distinguishes them from open-end funds and impacts investor returns.

The passage discusses that the profitability of carry and momentum currency strategies is often attributed to several factors. Option A suggests it’s fair compensation for systematic risk, which is a common economic explanation for persistent market anomalies. Option B posits that the profitability is illusory due to transaction costs, a valid concern in trading but not the primary explanation for these strategies’ observed historical success. Option C suggests unpredictability limits arbitrage, which is partially true but doesn’t fully explain the consistent profitability. Option D proposes trading against central banks, which can be a component of some strategies but isn’t the overarching reason for the profitability of both carry and momentum strategies as presented in the text. The text implies that these strategies offer returns that are not entirely explained by simple market movements, suggesting a compensation for risk or a market inefficiency that allows for such returns.

The question tests the understanding of the regulatory framework for managed futures in the United States. The Commodity Futures Trading Commission (CFTC) was established in 1974 to oversee futures and derivatives trading. The National Futures Association (NFA), an industry-supported self-regulatory organization, was created in 1982 and partners with the CFTC to provide primary oversight, including auditing member firms like FCMs, IBs, CPOs, and CTAs. While the CFTC has broad oversight, the NFA plays a crucial role in the day-to-day auditing and regulation of these entities. Therefore, the NFA, in conjunction with the CFTC, is the principal overseer.

This question tests the understanding of how leverage impacts risk and return in hedge fund strategies, specifically focusing on the implications of increased leverage on volatility and potential drawdowns. While leverage can amplify gains, it also magnifies losses and increases the sensitivity of the fund’s net asset value (NAV) to market movements. A higher degree of leverage means that even small adverse price changes can lead to substantial declines in NAV, increasing the probability of significant drawdowns and potentially triggering margin calls. This heightened sensitivity is a direct consequence of the amplified exposure to underlying assets. Therefore, a fund employing higher leverage is inherently exposed to greater volatility and a higher risk of substantial capital erosion.

The provided exhibit illustrates a forward curve for natural gas. A positively sloped forward curve, also known as contango, typically indicates that the market anticipates higher prices in the future. This upward slope is often driven by factors such as storage costs, the cost of financing a position, and the expectation of future demand exceeding current supply. In the context of natural gas, storage is feasible but can be expensive, especially as capacity limits are approached. This expense, coupled with the potential for increased demand during colder months, can lead to a situation where future delivery prices are higher than spot prices to compensate for these costs and risks. The question tests the understanding of how storage costs and demand expectations influence the shape of a commodity’s forward curve, specifically in the context of a storable commodity like natural gas.

The question tests the understanding of how short selling costs and rebates impact the overall return of a long/short equity strategy. In the provided scenario, the short rebate is 1.5% on the shorted amount of $50, resulting in $0.75. This rebate is composed of interest earned on the proceeds of the short sale (2%) and the cost to borrow the shares (0.50%). The net effect of the short rebate is a credit to the fund. The total dollar return from the short position is calculated as the price appreciation of the shorted security (which is a gain for the short seller, hence a positive contribution to the fund’s return), plus the net rebate received, minus any dividends paid on the shorted security. The price appreciation on the shorted security ABC is a decline of 5% on $50, which is a gain of $2.50 for the short seller. The net rebate is $0.75. The dividend paid on the shorted security is $1.00. Therefore, the total dollar change from the short position is $2.50 (price gain) + $0.75 (net rebate) – $1.00 (dividend paid) = $2.25. The question asks for the total dollar change from the short position, which is $2.25.

This question assesses the understanding of the strategic purpose of stop-loss orders in global macro trading, as articulated by experienced managers. The core principle is that a stop-loss should be triggered by a change in the market’s assessment of the trade’s viability, rather than a predetermined financial limit. Option A correctly captures this by emphasizing that the stop should signal the trade’s incorrectness. Option B is incorrect because while risk capital allocation is a broader portfolio management concept, the stop-loss itself is about trade execution discipline. Option C is flawed because setting a stop based solely on the maximum acceptable dollar loss ignores the market signal aspect. Option D is also incorrect as it focuses on the psychological aspect of conviction rather than the objective market indication of a flawed trade.

The commitment-weighted benchmark is constructed by aggregating the benchmark performance of individual funds within a portfolio, weighted by their respective commitments. This ensures that the benchmark reflects the same capital allocation strategy as the actual portfolio. The formula for this is: BM_P,T = (Σ(C_i * BM_i,T)) / Σ(C_i), where C_i is the commitment to fund i and BM_i,T is the benchmark for fund i at time T. This method directly addresses the issue of differing vintage-year structures and allocation strategies across funds by creating a comparable benchmark.

The Dodd-Frank Act significantly altered the regulatory landscape for investment advisers, including hedge funds. A key change was the elimination of the “private adviser exemption” under the Investment Advisers Act of 1940. This exemption previously allowed advisers with fewer than 15 clients, who did not publicly advertise, and did not advise registered investment companies, to avoid SEC registration. The Dodd-Frank Act removed this broad exemption, requiring most investment advisers, including hedge funds managing significant assets, to register with the SEC. While certain specific exemptions remain (e.g., for venture capital funds or foreign private advisers), the general private adviser exemption was removed, necessitating registration for many previously exempt entities.

The question probes the understanding of how intellectual property (IP) is valued and traded in the market. Unbundled IP refers to IP that can be owned and traded independently of other assets. Newly created or ‘ex ante’ IP, such as early-stage research or pending patents, carries significant uncertainty regarding its future value and potential for success. This uncertainty is akin to venture capital investments, where a high failure rate is expected, but a small number of successes can generate substantial returns. Mature IP, conversely, has established utility and a more predictable income stream, leading to more certain valuations and market pricing that reflects known risks like complexity and liquidity. Therefore, the characteristic that most accurately describes newly created, unbundled IP is its inherent uncertainty in value and potential for both significant loss and outsized gains, mirroring the risk profile of early-stage ventures.

A long/short equity hedge fund manager is evaluating an investment idea concerning Company XYZ’s upcoming earnings report. The manager believes the earnings will surpass the consensus forecast. To best capitalize on this conviction, the manager must select the most effective trading vehicle. Buying the stock directly offers participation in the upside but carries the full downside risk. Buying call options provides leveraged upside participation with limited downside risk (the premium paid), but the option’s value is also subject to time decay and volatility changes. Selling put options also offers a way to profit from an upward move or sideways trading, but it creates an obligation to buy the stock if it falls significantly, exposing the manager to substantial downside risk. Expressing the trade through sector ETFs is too broad and would not isolate the specific alpha from the Company XYZ earnings surprise. Therefore, buying call options is often considered an optimal way to express a bullish view on earnings with defined risk, especially when seeking leveraged upside from a specific event.

The question tests the understanding of how futures contracts differ from direct investments in underlying assets regarding currency risk. While direct investment in foreign equities exposes an investor to both the price movements of the equities and the fluctuations of the foreign currency, futures contracts on foreign assets generally do not carry this direct currency exposure. The primary exposure to currency risk in futures is limited to the margin posted and any unrealized profits or losses that have not yet been converted. Option (a) correctly identifies this limited exposure. Option (b) is incorrect because it overstates the currency risk, implying it’s the same as direct investment. Option (c) is incorrect as it suggests no currency risk at all, which is not entirely true due to margin and settlement flows. Option (d) is incorrect because it mischaracterizes the nature of currency risk in futures by comparing it to the full exposure of underlying assets.

The question probes the understanding of how institutional investors’ participation in commodity markets can influence price dynamics. The reference to “The Role of Institutional Investors in Rising Commodity Prices” by K. Black (2009) directly addresses this, suggesting a link between increased institutional investment and upward price movements. While other factors like supply and demand, geopolitical events, and macroeconomic conditions are crucial, the specific focus on institutional investor behavior points to this paper’s contribution. The other options represent broader market phenomena or different analytical frameworks not as directly tied to the specific research area highlighted by the reference.

Operational due diligence aims to assess the robustness and integrity of a hedge fund’s internal processes and management. While understanding the manager’s personality and background is part of the overall assessment (triangulation), the core of operational due diligence focuses on the infrastructure and systems that support the investment strategy. High personnel turnover, especially in key operational or senior management roles, can signal underlying issues with management, business culture, or operational stability, directly impacting the fund’s ability to execute its strategy and manage risk. Therefore, significant personnel turnover is a critical red flag that warrants deep investigation during operational due diligence.

When an investor replaces a poorly performing CTA manager with a new one, the investor effectively forfeits the ‘loss carryforward’ benefit. This means that any future gains generated by the new manager are subject to performance fees until the previous high-water mark is surpassed. If the new manager charges a 20% performance fee and the previous manager experienced a 25% drawdown, the new manager must generate a return of approximately 41.67% for the investor to simply break even on the lost performance fee potential. This is calculated as the required return to recover the drawdown (33.33%) divided by the net of fees portion (1 – 0.20), resulting in 0.333 / 0.80 = 0.4167 or 41.67%. The other options represent incorrect calculations or misinterpretations of the fee structure and drawdown recovery.

The question tests the understanding of the sources of return in commodity futures investments. According to the provided text, returns are derived from three primary components: the spot return (reflecting changes in the underlying commodity’s value), the collateral income (from the return on cash collateral, typically Treasury bills), and the roll return (resulting from changes in the futures basis). While spot returns are influenced by supply and demand, and collateral income is a function of prevailing interest rates, the roll return is specifically linked to the shape of the forward curve and the cost of carry. The text emphasizes that roll yield and collateral return are generally the larger contributors to total return, with spot return providing diversification benefits. Therefore, the most accurate description of the primary drivers of return, beyond the spot price movement itself, includes the income from collateral and the impact of rolling futures contracts.

The question tests the understanding of how a General Partner’s (GP) personal capital contribution, often referred to as ‘hurt money,’ aligns their incentives with those of the Limited Partners (LPs). A significant personal investment by the GP directly exposes them to potential losses, thereby mitigating the incentive for excessive risk-taking. This alignment is crucial because it discourages the GP from pursuing strategies that might yield high short-term gains but carry disproportionate risk, or from neglecting the fund if profitability becomes uncertain. The other options describe potential outcomes or related concepts but do not directly address the primary purpose of the GP’s capital contribution in managing risk.

The core principle of intergenerational equity in endowment management is to balance the needs of current beneficiaries with the imperative to preserve the real value of the endowment for future generations. This is often quantified as a 50% probability of maintaining the inflation-adjusted value of the corpus in perpetuity. A higher probability (e.g., 75%) favors future generations by allowing for higher current spending, while a lower probability (e.g., 25%) favors the current generation by permitting even higher spending, albeit with a reduced chance of perpetual survival. Therefore, the primary objective is to ensure the endowment’s long-term purchasing power remains intact.

When an investor decides to allocate capital to Commodity Trading Advisors (CTAs), a critical decision point is the number of CTAs to include in the portfolio. While investing in a single CTA offers simplicity, it concentrates risk and limits exposure to diverse trading strategies. To mitigate these risks and achieve diversification, a portfolio approach is generally recommended. The text suggests that a minimum of six CTAs is typically required to establish a reasonable level of diversification. This diversification is crucial for managing the inherent volatility and idiosyncratic risks associated with individual CTA performance.

The AIMA questionnaire is a standard framework for due diligence on Fund-of-Funds (FoFs). Section 5, ‘Due diligence/manager selection,’ specifically addresses the process by which an FoF manager evaluates and selects underlying hedge fund managers. Option (a) correctly identifies the need to understand the minimum criteria for manager approval, the time investment in due diligence, the success rate of manager selection, the verification processes for manager-provided data, the frequency of on-site visits, and the assessment of third-party service providers. These are all core components of a robust manager selection process as outlined in the AIMA guidelines. Option (b) is incorrect because while fee structures are important (covered in Section 2), they are not the primary focus of the manager selection process itself. Option (c) is incorrect as performance is a separate due diligence area (Section 3) and not the sole determinant of manager selection. Option (d) is incorrect because while portfolio construction (Section 6) is related, it deals with the ongoing management of the portfolio, not the initial selection criteria.

The question tests the understanding of the challenges in constructing and tracking hedge fund indices, particularly the issue of access bias. Investable indices, by their nature, must select a subset of hedge funds that meet specific criteria such as liquidity, transparency, and willingness to accept new investors. This selection process inherently favors funds that are more accessible and potentially less exclusive or high-performing, leading to a bias where the index components may not be truly representative of the broader hedge fund universe. The explanation highlights that top-performing managers might be less inclined to join an index, thus creating an ‘access bias’ that can lead to lower aggregate returns for the index compared to the overall market. The other options describe valid challenges but do not directly address the systematic skew in fund selection that characterizes access bias.

The provided exhibit indicates that the correlation between U.S. inflation and the energy commodity index is statistically significant at the 1% level (denoted by ‘a’). This suggests a strong positive relationship, meaning that as U.S. inflation rises, energy commodity returns tend to increase. While other commodity indices show some correlation with U.S. inflation, the energy sector exhibits the most robust and statistically significant positive association, making it the most direct beneficiary of rising U.S. inflation among the listed commodity categories.

The question tests the understanding of how different time horizons impact the correlation between commodity prices and inflation, specifically focusing on the U.S. market as presented in Exhibit 27.2. The exhibit shows that for the ‘Composite’ commodity index, the correlation with U.S. inflation is 0.532 for a 1-year horizon, 0.568 for a 3-year horizon, and 0.658 for a 5-year horizon. All these correlations are positive and statistically significant (indicated by ‘a’). This indicates a strengthening positive relationship as the time horizon increases. The text also supports this by stating that rolling correlations for U.S. inflation fluctuate strongly in the short run but are more stable and on average positive when considered over periods beyond three years, concluding that in the long run, a positive relationship exists. Therefore, the most accurate statement is that the positive correlation between commodities and U.S. inflation tends to strengthen with longer time horizons.

Limited partners (LPs) often find it challenging to access top-tier private equity funds due to the competitive nature of fundraising and the prevalence of invitation-only offerings. Funds of funds (FoFs) play a crucial role in bridging this gap by leveraging their industry expertise, established networks, and deep understanding of the private equity landscape. They possess the necessary skills in due diligence, negotiation, and contract structuring, along with access to research and models, to identify and secure investments in high-performing funds, including those that are less accessible to individual investors. This allows LPs to gain exposure to sought-after managers and potentially achieve superior returns, even if they lack the direct resources or relationships to do so themselves.

The question tests the understanding of the sources of return in commodity futures investments. According to the provided text, returns are derived from three primary components: the spot return (reflecting changes in the underlying commodity’s value), the collateral income (from the return on cash collateral, typically Treasury bills), and the roll return (resulting from changes in the futures basis). While spot returns are influenced by supply and demand, and collateral income is a function of prevailing interest rates, the roll return is specifically linked to the shape of the forward curve and the cost of carry. The text emphasizes that roll yield and collateral return are generally the larger contributors to total return, with spot return providing diversification benefits. Therefore, the most accurate description of the primary drivers of return, excluding diversification benefits, would encompass the income from collateral and the gains or losses from managing futures positions over time due to basis changes.

The question tests the understanding of how commodity index returns are calculated, specifically focusing on the distinction between spot return and excess return when a roll occurs. On a roll date, the spot index uses the newly initiated futures contracts for the next expiration cycle, while the excess return index continues to use the expiring contracts. The difference between these two returns, when calculated on the same day but reflecting different contract sets, represents the roll return. In Exhibit 26.2, the spot return is -3.43% and the excess return is -3.46%. The difference, -3.43% – (-3.46%) = 0.03%, is the positive roll return. The total return index, which accounts for both price changes and roll returns, would reflect this combined effect. Therefore, the spot return is higher than the excess return due to the positive roll return.