CAIA Level 2 Quiz 36

The question probes the practical challenges of implementing arbitrage strategies between private real estate and REITs. The provided text highlights two primary difficulties: the significant time, transaction costs, capital, and expertise required for private real estate transactions, and the near impossibility of short-selling privately held real estate. While REITs offer greater liquidity, shorting them can still be challenging during periods of extreme market stress. Option A correctly identifies the difficulty in short-selling private real estate and the time/cost involved in private transactions. Option B is incorrect because while REITs are more liquid, shorting them is not always easy, especially in stressed markets. Option C is incorrect as the primary issue isn’t the availability of REITs, but the mechanics of shorting them and the nature of private real estate transactions. Option D is incorrect because the core problem isn’t the lack of well-capitalized properties, but the operational and market-access barriers to arbitrage.

The question probes the understanding of how transaction costs impact the net returns from art investments. The provided text highlights that typical round-trip transaction costs can be as high as 25%. It also states that the median real return to holding art over extended periods is 2.2%. To cover the 25% transaction costs, assuming a constant annual return, the appreciation needed would be 25% of the initial investment. If the annual real return is 2.2%, it would take approximately 25% / 2.2% = 11.36 years to recoup these costs through price appreciation alone. Therefore, a period of 10 years of price appreciation is a reasonable estimate to cover these costs, making option (a) the most accurate.

The CAIA designation emphasizes a practical understanding of alternative investments. When considering intellectual property (IP) as an asset class, particularly in the context of film production as illustrated by the provided exhibits, the core challenge lies in the inherent asymmetry and non-normal distribution of returns. Traditional risk and return metrics, such as Sharpe ratios and regression betas, are derived assuming normal distributions. The K4 distribution, used in the exhibit, explicitly acknowledges and models these deviations, including skewness and fat tails, which are characteristic of many real-world alternative assets like film investments. Therefore, analysts must employ specialized techniques to accurately assess risk and construct portfolios of such assets, rather than relying on standard financial models that would be inappropriate.

Operational due diligence for a convertible arbitrage fund requires a thorough examination of its pricing and hedging methodologies. A critical aspect is ensuring consistency between the models used for pricing the convertible security and its embedded options, and the models used for hedging the associated risks. Using disparate models can lead to miscalculations of risk exposures and unintended portfolio vulnerabilities. Therefore, verifying that a single, integrated model is employed for both pricing and hedging is paramount to understanding the fund’s risk management framework and the reliability of its valuation processes.

The question tests the understanding of how different types of inflation impact commodity returns, specifically focusing on the hedging properties. The provided text indicates that unexpected inflation generally has a larger positive impact on commodity returns than expected inflation, suggesting a stronger hedging capability against unexpected price movements. The regression results in Exhibit 27.4 further support this, showing higher positive coefficients for unexpected inflation across several indices, particularly for the composite and energy indices. The text also highlights that commodities with limited storability, like copper and heating oil, offer a better hedge against unexpected inflation because increased demand directly drives up their prices, unlike highly storable commodities where inventory depletion is a prerequisite for price impact. Therefore, an investor seeking to hedge against unanticipated inflationary pressures would find commodities with limited storability to be more effective.

The question tests the understanding of how technical analysis, specifically trend-following strategies like moving averages, can generate profits. The provided text explains that arbitrageurs, while moving prices towards fundamental values, are limited by factors like risk aversion and capital constraints. This limitation allows prices to exhibit trends that technical analysis can exploit. The core idea is that new information causes a delayed movement towards equilibrium, creating predictable price trends. Moving average systems, by identifying these trends (e.g., price staying above a moving average), allow traders to profit from the continuation of these trends. The other options are incorrect because while arbitrageurs are mentioned, their limitations are the *reason* for trends, not the direct source of profit for technical traders. Market stress is a condition where opportunities arise, but it’s the price behavior during stress that technical analysis targets. Finally, while technical analysis is applied to futures, its profitability is linked to price trends, not directly to the underlying asset’s volatility in isolation.

The question asks to identify the most appropriate benchmark for a private equity fund’s performance, considering its potential impact on an investor’s public equity allocation. The provided text highlights that private equity allocations are often made at the expense of public equity, implying an opportunity cost. Therefore, comparing private equity performance to public market equivalents (PMEs) is a standard and justified practice. PME analysis directly addresses this opportunity cost by evaluating what an investor would have earned by investing the same cash flows in a public market index. While peer group analysis (comparing to similar PE funds) and absolute return benchmarks (like a fixed hurdle rate) are also used, they don’t directly capture the trade-off with public equity investments as effectively as PME. The CAC 40 Index is presented as an example of a public market benchmark.

This question tests the understanding of Type 2 conflicts of interest in private equity, as defined by Walter (2003). Type 2 conflicts arise when a fund manager’s relationships with multiple clients create a situation where the manager might favor one client over another. This is distinct from Type 1 conflicts, which involve a conflict between the firm’s economic interests and its clients’ interests, typically addressed through alignment of interests. In the scenario, the manager advising a new fund while simultaneously managing an existing one, with potential for differing investment strategies or opportunities, directly creates a situation where the manager could prioritize one fund’s interests over the other, thus fitting the definition of a Type 2 conflict.

Defined Contribution (DC) plans shift the investment risk and longevity risk to the employee. Unlike Defined Benefit (DB) plans where the employer guarantees a specific retirement income, DC plans offer no such guarantee. The employee’s retirement income depends on their contribution levels, investment performance, and how long they live. Therefore, an employee in a DC plan faces the risk of outliving their accumulated assets if their savings are insufficient or their lifespan is longer than anticipated, a risk known as longevity risk. In contrast, DB plans typically manage longevity risk by the employer, as the benefit is paid for the retiree’s lifetime.

The question tests the understanding of how commodity price volatility impacts the risk premium and convenience yield, particularly in the context of momentum strategies. Research indicates a positive relationship between volatility and convenience yield. During periods of positive risk premium, an increase in volatility leads to a rise in both the risk premium and convenience yield. Conversely, in periods of negative risk premium, increased volatility causes a decline in these components. Momentum strategies that are positively correlated with volatility can therefore capture excess returns when volatility spikes, especially if these spikes are persistent and align with the existence of convenience yield. The other options are incorrect because they misrepresent the relationship between volatility, risk premium, and convenience yield or misattribute the primary driver of momentum profits.

The “trading level” in the context of a CTA’s portfolio, as described in the provided text, represents the notional value of the assets under management that the CTA is actively trading. This is the figure used for calculating returns and fees. The exhibit shows a total margin requirement of $131,845,567 for a portfolio with a stated trading level of $2 billion. The text explicitly states that the choice of $2 billion as the denominator is arbitrary and defines it as the trading level. The actual cash required for margin is significantly less than the trading level, highlighting the leverage inherent in futures trading. Therefore, the trading level is the basis for performance and fee calculations, not the actual cash held or the margin required.

Operational due diligence for hedge funds, particularly those employing complex strategies like convertible arbitrage, necessitates a thorough examination of the valuation process. The Lipper Convertible Fund case highlights the critical importance of verifying the quality and source of pricing inputs. In convertible arbitrage, inputs such as volatility and credit spreads are crucial for accurate pricing models. When these inputs are estimated rather than directly observable, or when they deviate significantly from market consensus, a robust due diligence process must scrutinize their reliability and the justification for any discrepancies. This includes understanding how the fund manager handles unobservable inputs and whether the valuation methodology is sound and consistently applied, as failures in this area can lead to material misstatements of fund performance and value, as demonstrated by the intentional overstatement of asset values in the Lipper case.

The question probes the understanding of how behavioral biases can influence market prices, specifically in the context of managed futures and trend-following strategies. The provided text highlights that anchoring and the disposition effect can lead to underreaction to new information, causing prices to initially move in a trend. Subsequently, biases like herding, feedback, confirmation, and representativeness can cause overreaction and price overshoot. The core concept tested here is the cyclical nature of price movements driven by these psychological factors, leading to trends that eventually reverse. Option A correctly identifies that the initial underreaction, followed by overreaction, is a consequence of these behavioral influences, which CTAs aim to exploit through trend identification and timely exits. Option B is incorrect because while market inefficiencies exist, the question specifically focuses on the behavioral drivers of price trends, not just general inefficiencies. Option C is incorrect as the disposition effect primarily contributes to the initial underreaction, not the subsequent overreaction. Option D is incorrect because while technical analysis is used by CTAs, the question is about the underlying behavioral causes of the price movements that technical analysis seeks to identify, not the tools themselves.

The question probes the diversification benefits of Funds of Funds (FoFs) in the context of single-strategy portfolios. Research indicates that a relatively concentrated portfolio of 3-5 hedge funds, equally weighted, can achieve a high correlation with its strategy index and significantly reduce manager-specific risk. This implies that adding more funds beyond this range offers diminishing marginal benefits for diversification within that specific strategy. Therefore, a portfolio of 15 single-strategy funds would likely offer only marginal additional diversification benefits compared to a portfolio of 5 funds, as most of the strategy-specific risk would have already been mitigated.

The question tests the understanding of how a crack spread hedge functions to lock in a refiner’s margin. In Scenario A, the refiner buys crude oil at $90.06/barrel and sells gasoline at $98.66/barrel and heating oil at $104.24/barrel. The cash market margin is calculated as the weighted average of the output prices minus the input price. For a 3:2:1 spread, this is [(2 * $98.66) + (1 * $104.24) – (3 * $90.06)] / 3 = ($197.32 + $104.24 – $270.18) / 3 = $31.38 / 3 = $10.46 per barrel. The futures market shows the refiner is long crude at $90.06/barrel and short gasoline at $99.16/barrel and heating oil at $104.54/barrel. The futures crack spread is [(2 * $99.16) + (1 * $104.54) – (3 * $90.06)] / 3 = ($198.32 + $104.54 – $270.18) / 3 = $32.68 / 3 = $10.89 per barrel. The net profit/loss from the hedge is the difference between the futures crack spread and the cash market crack spread, adjusted for the difference in futures and cash prices for each component. In this scenario, the cash market margin is $10.46/barrel. The futures market locked in a spread of $10.89/barrel. The difference between the futures price and cash price for crude is $90.06 – $90.06 = $0. For gasoline, it’s $99.16 – $98.66 = $0.50. For heating oil, it’s $104.54 – $104.24 = $0.30. The net gain/loss on the futures contracts is (40 contracts * $0.50/gallon * 42 gallons/barrel) + (20 contracts * $0.30/gallon * 42 gallons/barrel) – (60 contracts * $0/barrel) = $840 + $252 – $0 = $1,092. Since there are 60,000 barrels of crude, the gain per barrel is $1,092 / 60,000 barrels = $0.0182 per barrel. The total margin achieved is the cash margin plus the gain from the hedge: $10.46 + $0.0182 = $10.4782. However, the question asks for the net profit/loss on the hedge itself. The futures crack spread was $10.89/barrel and the cash crack spread was $10.46/barrel. The difference of $0.43/barrel represents the gain from the hedge. This gain is realized because the futures prices for the products were higher than the cash prices, and the futures price for crude was the same as the cash price. Therefore, the hedge resulted in a net gain of $0.43 per barrel.

The Limited Partnership Agreement (LPA) is the foundational document governing a private equity fund. It meticulously outlines the operational and economic terms, including the distribution waterfall, management fees, and investor protection clauses. These clauses are designed to align the interests of the General Partner (GP) with those of the Limited Partners (LPs) and mitigate potential conflicts of interest, such as moral hazard or opportunism. While other documents like the Private Placement Memorandum (PPM) and Subscription Agreement are crucial for fund offering and investor commitment, the LPA specifically details the internal structure and operational framework of the fund itself.

Venture capital (VC) fund partners typically engage deeply with the companies they invest in, often taking active roles on the board of directors and contributing to strategic planning. This hands-on approach is characteristic of VC investments, which aim to foster growth in early-stage companies. Buyout funds, conversely, focus on more established businesses and their strategies often revolve around financial engineering (modifying capital structure) and operational enhancements, rather than the fundamental business model development typical of VC. Funds of funds offer diversification but are primarily a vehicle for accessing the broader private equity market, not a direct investment strategy with the same level of operational involvement as VC.

The provided text highlights that larger endowments tend to outperform smaller ones, particularly in alternative asset classes. This outperformance is attributed to several factors, including superior manager selection skills, which are often linked to a ‘first-mover advantage’ where larger endowments gain earlier access to top-performing managers, many of whom later close their funds to new investors. The text also suggests that these larger endowments benefit from a sophisticated fund-selection process and potentially better information processing capabilities once they become limited partners. While access to talented alumni networks is mentioned as a contributing factor to overall success, the direct link to outperformance in specific asset classes, especially alternatives, is more strongly tied to the ability to identify and secure access to skilled managers before others do.

The “entry and establish” phase for both fund managers and investors in private equity is characterized by significant hurdles. For new fund managers, the primary challenge is the lack of a verifiable track record, making it difficult to attract initial capital. This often leads them to adopt specialized or differentiated investment strategies to stand out. Similarly, new limited partners face an informational disadvantage, struggling to identify and gain access to top-tier fund managers, especially when those managers’ funds are oversubscribed. This initial phase requires both parties to overcome substantial barriers to entry before a stable relationship can be built.

The question asks to evaluate the performance of PE Fund 1 relative to its benchmark. The provided data shows that PE Fund 1’s IRR of 17% falls between the upper quartile (13.2%) and the maximum return (34.8%) of the sample of 31 European private equity funds with a vintage year of 2000 focusing on buyouts. This indicates that PE Fund 1 performed exceptionally well compared to its peer group, exceeding the median and upper quartile returns. Option B is incorrect because while PE Fund 2’s IRR (13%) is above the median (6.5%), it falls within the second quartile, making its performance less impressive than Fund 1’s. Option C is incorrect as it misinterprets the benchmark comparison; Fund 1’s performance is strong relative to its PE peers, not necessarily the public market equivalent in this specific comparison. Option D is incorrect because the Public Market Equivalent (PME) calculation is a separate analysis, and while Fund 1 outperformed the CAC40 index by 7.4%, the question specifically asks for a comparison to its private equity benchmark.

Systematic trading strategies, particularly trend-following ones, are often favored for their scalability and reduced reliance on individual trader discretion. Research suggests that systematic approaches tend to outperform discretionary strategies on a risk-adjusted basis, especially during market downturns. They also exhibit lower drawdowns and higher Sharpe ratios, indicating better risk management. The ability to systematically manage risk and avoid emotional decision-making contributes to their robustness, especially in volatile market conditions. Discretionary strategies, while potentially offering higher returns in rising markets, are more susceptible to key-person risk and emotional biases, making them less scalable and potentially more volatile.

The Dodd-Frank Act mandates that hedge fund managers register with either the SEC or state securities authorities based on their Regulatory Assets Under Management (RAUM) and the location of their principal office. Specifically, managers with AUM between $25 million and $100 million are considered midsize. If such a midsize adviser’s principal office is in a state that requires investment adviser registration, they must register with that state. If their principal office is in a state that does not require registration, or if they manage hedge funds where they would not be subject to examination by that state’s securities commissioner, they would register with the SEC. Managers with AUM exceeding $100 million (or $150 million if they don’t manage separately managed accounts) generally register with the SEC. Therefore, a manager with $75 million in AUM whose principal office is in a state that requires investment adviser registration must register with that state.

The SEC employs a risk-based approach to inspections. Funds with a high-risk profile, as indicated by factors such as substantial assets under management, a retail client base, affiliated brokers, multiple affiliates, performance-based fees, or a weak compliance program, are more likely to be targeted for routine inspections, often within a year of registration. Cause inspections are triggered by specific suspicions of violations, while sweep inspections focus on particular themes or geographic areas. Therefore, a fund manager with a high-risk profile should anticipate a more frequent inspection schedule.

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. Conversely, building an in-house team allows for greater control and customization but requires substantial internal expertise and resources for selection, monitoring, and portfolio construction. For investors making a substantial allocation, a managed account platform is often preferred because it provides 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 objectives, such as tax considerations or ESG mandates, which might be more challenging to achieve through a pooled fund structure.

The Projected Benefit Obligation (PBO) represents the present value of all future retirement benefits that a company expects to pay to its current employees, considering future salary increases and service periods. The Accumulated Benefit Obligation (ABO) only considers benefits accrued to date based on current salaries and service. Therefore, for a young firm with young employees who have short service histories and are expected to receive significant salary increases before retirement, the PBO will be substantially larger than the ABO. The PBO incorporates assumptions about future events like salary growth and longer service periods, which are not factored into the ABO. The difference between PBO and ABO is primarily driven by these future-oriented assumptions.

The question probes the understanding of the ‘increased allocation to active funds hypothesis’ as a reason for the observed decline in hedge fund alpha and rise in beta. This hypothesis posits that as more capital flows into hedge funds, their systematic risk (beta) increases due to the trading decisions of investors who also hold traditional assets. During times of financial stress, these investors might liquidate both types of investments, leading to a higher correlation between traditional and alternative asset classes. The other options represent different hypotheses or related concepts. The ‘fund bubble hypothesis’ suggests that an influx of less-skilled managers dilutes overall performance. The ‘capacity constraint hypothesis’ argues that alpha is a zero-sum game, and increased assets under management reduce the per capita alpha available. Convertible and merger arbitrage are examples of strategies that provide diversification benefits by offering returns not highly correlated with traditional assets, which is a separate concept from the reasons for declining alpha.

The question tests the understanding of how to manage liquidity risk in an endowment portfolio heavily invested in illiquid alternatives. The provided text highlights that illiquidity risk increases during crises, making it difficult to exit investments and meet capital calls. The core strategy to mitigate this is to align investment liquidity with the investor’s time horizon and cash needs. Tier 1 assets (short-term fixed income) and Tier 2 assets (liquid, risky assets like stocks) are recommended for meeting short-term spending and capital calls. Tier 3 assets (illiquid alternatives like private equity) are for long-term growth and should not be relied upon for short-term liquidity. Therefore, the most prudent approach to manage potential liquidity shortfalls when facing ongoing capital calls for illiquid investments is to increase the allocation to more liquid asset classes that can be readily converted to cash without significant loss, thereby providing a buffer for unexpected cash demands.

This question tests the understanding of how currency momentum strategies are implemented and the underlying logic. A momentum strategy involves taking long positions in currencies that have recently appreciated and short positions in currencies that have recently depreciated. The profit calculation for a long position in a currency (FCU) that has appreciated is based on the expectation that this appreciation will continue. If the spot rate at time t+1 (St+1) is higher than the spot rate at time t (St), the investor profits. The formula provided in the material for a long position in a depreciating currency (which is the inverse of a long position in an appreciating currency) is (St – St+1) / St-1. Conversely, for a long position in an appreciating currency, the profit is (St+1 – St) / St. Therefore, if the FCU has increased in value (St+1 > St), a long position profits if the trend continues (St+1 > St), and the profit is calculated as the change in the spot rate relative to the previous spot rate. Option A correctly reflects this by stating that a long position in a currency that has appreciated will be profitable if the future spot rate is higher than the current spot rate, with the profit calculated as the difference between the future and current spot rates, normalized by the current spot rate.

The core principle of momentum-based strategies is the expectation that past performance will continue into the future. This means that assets that have recently performed well are expected to continue their upward trend, and assets that have performed poorly are expected to continue their downward trend. Option (a) accurately reflects this by stating that the strategy bets on the continuation of existing price trends. Option (b) describes mean reversion, which is the opposite of momentum. Option (c) describes a strategy that seeks to exploit inefficiencies by arbitraging price differences, which is not the primary mechanism of momentum. Option (d) describes a strategy focused on fundamental value, not price trends.

The CAIA curriculum emphasizes that when hedge fund managers present performance data in their 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, showing a 10% increase in an equity account without mentioning that the broader market surged by 40% during the same period would be considered misleading. Performance must also be presented net of all fees, with specific exceptions for gross performance figures (if presented alongside net figures), custodial fees, and certain one-on-one presentations to sophisticated investors. Testimonials and endorsements are prohibited.