CAIA Level 2 Quiz 96

Trend-following strategies, a core component of technical analysis in managed futures, aim to capitalize on persistent price movements. Moving average systems, particularly dual crossover strategies, generate signals by comparing short-term and long-term price trends. When the short-term moving average crosses above the long-term moving average, it signals a potential upward trend, prompting a buy. Conversely, a cross below indicates a potential downtrend, signaling a sell. This approach is based on the premise that past price trends, when smoothed by moving averages, can predict future price direction, especially in markets where arbitrageurs cannot immediately correct price deviations from fundamental values.

This question tests the understanding of how to manage liability and segregation when allocating capital to multiple Commodity Trading Advisors (CTAs). Option A correctly identifies that using separate Special Purpose Vehicles (SPVs) for each CTA, with each SPV opening its own brokerage account, provides the highest level of segregation and avoids cross-liability between the managers’ trading activities. This structure ensures that the liabilities incurred by one CTA do not impact the assets managed by another. Option B describes a single SPV with subaccounts, which, while segregating trade information, typically involves cross-collateralization and cross-liability, thus not offering the same level of protection. Option C describes a single managed account where a single CTA has trading authority, which is a simpler structure but doesn’t address the allocation to multiple managers. Option D describes a Protected Cell Company (PCC), which is a valid structure for segregation, but the question specifically asks about the most effective method for segregating investments and avoiding cross-liability when allocating to multiple managers, and separate SPVs offer a more direct and robust solution in this context, especially when considering the formation of distinct legal entities for each manager.

The AIMA questionnaire is a standard framework for due diligence on Fund-of-Funds (FoFs) managers. 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 core purpose of this section, which is to scrutinize the FoF’s methodology for vetting potential investments. Options (b), (c), and (d) describe elements that might be *part* of a due diligence process (e.g., operational efficiency, performance metrics, or compliance checks), but they do not represent the overarching objective of the ‘Due diligence/manager selection’ section as defined by the AIMA framework.

The endowment model, as discussed in the context of institutional investing, emphasizes a strategic asset allocation approach. While studies on pension plans historically attributed a significant portion of return variance to strategic asset allocation (91.5%-93.6%), research on endowments, such as Brown, Garlappi, and Tiu (2010), indicated a different attribution. This research suggested that while strategic asset allocation still played a role (74.2%), market timing (14.6%) and security selection (8.4%) contributed more significantly to endowment fund returns compared to traditional pension plans. This implies that endowments are more active in their management and selection processes. The question tests the understanding of how return attribution differs between traditional pension plans and the endowment model, highlighting the increased importance of active management components like market timing and security selection in the latter.

The payoff-distribution approach to hedge fund replication aims to construct a portfolio that mimics the return distribution of a target hedge fund. This is achieved by using a reserve asset (or a combination of assets) and applying a transformation function derived from the cumulative distribution functions (CDFs) of both the hedge fund and the reserve asset. Specifically, if F_HF(x) is the CDF of the hedge fund returns and F_R(r) is the CDF of the reserve asset, and H(y) is the inverse CDF (quantile function) of the hedge fund, then the replicating portfolio’s payoff function G(x) is constructed as G(x) = H(F_R(x)). This function effectively maps the returns of the reserve asset to the desired payoff distribution of the hedge fund. The question tests the understanding of this core mechanism by asking how the reserve asset’s return is transformed to match the hedge fund’s distribution, which is precisely what the inverse CDF of the hedge fund applied to the CDF of the reserve asset achieves.

Exhibit 8.9 illustrates the risk profiles of venture capital and buyout funds in Europe versus the U.S. The exhibit shows that U.S. venture capital funds, on average, exhibit a higher probability of achieving returns in the higher probability bands (e.g., 15-20% and 20-25%) compared to European venture capital funds. This suggests a generally more aggressive risk-return profile for U.S. venture capital investments, potentially due to factors like market maturity, access to capital, and a more developed ecosystem for high-growth startups. Conversely, European venture capital funds tend to have a higher probability of returns in the lower probability bands (e.g., 0-5% and 5-10%), indicating a potentially more conservative or less mature venture capital market during the period studied.

The core-satellite approach in private equity portfolio construction involves segmenting the portfolio into two distinct parts. The ‘core’ typically comprises investments in established, high-quality fund managers with a track record of generating predictable, stable returns. These are often seen as the ‘safe bet’ and provide a foundational level of performance. The ‘satellite’ portion, conversely, is designed for higher growth potential and often involves less diversified strategies or managers with a more specialized focus, such as venture capital or distressed investments. This segment is where investors might take on more risk in pursuit of outsized returns. The question asks about the primary characteristic of the ‘core’ portfolio within this framework. Option A correctly identifies that the core aims to exploit established relationships and generate predictable base returns, aligning with the description of a stable, foundational component. Option B mischaracterizes the core by associating it with aggressive, risk-seeking strategies, which is the domain of the satellite. Option C incorrectly suggests the core’s primary goal is to minimize idle liquidity, which is a broader objective for the entire portfolio, not specific to the core’s defining characteristic. Option D misrepresents the core by linking it to a limited universe of accessible funds, which is more characteristic of early-stage portfolio building rather than the established relationships that define the core.

The question tests the understanding of how tax regulations, specifically those concerning ‘dealer sales’ in the U.S., could influence the portfolio management decisions of Real Estate Investment Trusts (REITs). The relaxation of these rules in 2008, which reduced the holding period and adjusted the percentage of assets that could be sold without incurring a prohibited transaction tax, aimed to provide REITs with greater flexibility. This flexibility allows REITs to potentially engage more actively in property turnover and capitalize on market timing, thereby reducing the divergence between their market prices and the underlying private real estate values that was previously attributed, in part, to these tax constraints. Therefore, the relaxation of dealer sales rules would likely enhance a REIT’s ability to manage its portfolio more dynamically and potentially align its market valuation more closely with underlying asset values.

The question tests the understanding of liquidity risk management for endowments, specifically concerning the timing and impact of capital calls and distributions from illiquid alternative investments. The provided text highlights that during a crisis, distributions slow down while capital calls continue, creating a liquidity crunch. A key strategy to mitigate this is to align the timing of new commitments with expected distributions from existing, maturing investments. Laddering commitments, as suggested by Siegel (2008), involves spreading new commitments over multiple years and ideally timing them such that distributions from older funds can cover capital calls for newer ones. This approach smooths out the cash flow impact and reduces the need for distressed asset sales or borrowing during periods of market stress. Option B is incorrect because while overcommitment can be a strategy, it exacerbates liquidity risk if not managed carefully against distributions. Option C is incorrect as focusing solely on the total commitment amount without considering the timing of calls and distributions doesn’t address the liquidity mismatch. Option D is incorrect because while reducing illiquid assets is a valid strategy, the question asks about managing the existing illiquid allocation, and laddering is a specific technique for that purpose.

The core of the private equity investment process begins with establishing clear portfolio objectives. These objectives serve as the foundational guide for all subsequent decisions, including strategic asset allocation, fund selection, diversification strategies, and liquidity management. Without well-defined objectives, the entire investment process lacks direction and a basis for evaluating success. While other elements like fund selection and liquidity management are critical components, they are implemented *after* the objectives have been set. Market analysis informs the objectives, but the objectives themselves are the starting point for the investor’s strategy.

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). While leverage can explain some of this difference, the text suggests that it accounts for less than half. The remaining discrepancy is attributed to factors such as the lower accuracy of smoothed appraisals, which tend to lag true market prices and exhibit correlated under- and overvaluations. Furthermore, the text posits that the trading of real estate investments in equity markets can introduce liquidity-induced volatility, meaning REIT prices might fluctuate due to broader equity market sentiment rather than solely reflecting intrinsic changes in the underlying real estate values. Therefore, the most comprehensive explanation for the higher volatility in market-based returns, even after accounting for leverage, points to the influence of equity market dynamics and the inherent smoothing in appraisal methods.

The Capital Asset Pricing Model (CAPM) posits that the expected return of an asset is determined by the risk-free rate, the asset’s systematic risk (beta), and the market risk premium. While CAPM is theoretically applicable to real assets, its practical application to private equity (PE) funds faces challenges due to the model’s underlying assumptions. Specifically, CAPM assumes investors hold well-diversified portfolios, which may not always hold true for all PE investors, especially those with concentrated holdings. Furthermore, PE investments often lack the liquidity and transparency assumed by CAPM, making it difficult to accurately estimate beta and the market risk premium. The question asks about the primary limitation of applying CAPM to PE funds. Option A correctly identifies the difficulty in accurately estimating the required inputs (risk-free rate, market risk premium, and beta) due to the unique characteristics of PE investments, such as illiquidity and lack of public data. Option B is incorrect because while PE investors are often sophisticated institutions, the assumption of perfect diversification is not universally applicable to all PE investors, and this is a secondary concern compared to data availability. Option C is incorrect; while PE investments are illiquid, this is a factor contributing to the difficulty in estimating inputs, not the primary limitation itself. Option D is incorrect because the CAPM’s core principle is to reward systematic risk, not total risk, and this is a theoretical consideration rather than a practical limitation of applying the model to PE.

The question tests the understanding of the risk-return spectrum within real estate investment styles as defined by NCREIF. Core properties are characterized by stable income streams, low volatility, and a significant portion of returns derived from cash flow, making them the least risky and most bond-like. Value-added properties involve properties with potential for appreciation, moderate volatility, and often require active management such as repositioning or renovation, leading to less reliable income than core properties. Opportunistic properties, while not explicitly detailed in the provided text for this question, represent the highest risk and potential return, often involving development, significant redevelopment, or distressed assets with little to no current income. Therefore, a property with a high percentage of return from income and low volatility aligns with the definition of a core real estate investment.

The AIFMD aims to harmonize the regulation of alternative investment funds across the EU. A key aspect of this directive is the introduction of an EU-wide marketing passport for EU-based managers, allowing them to market funds to professional investors in other member states under a single authorization. Non-EU managers must adhere to the private placement rules of individual member states. The directive also mandates increased disclosure to investors and regulators to monitor systemic risk, and imposes requirements for appointing a depositary and maintaining due diligence documentation, all of which contribute to increased compliance costs for fund managers operating within or marketing to the EU.

The question tests the understanding of how film revenues are generated and how the mix of these revenue streams can shift over time. The provided text highlights that while total film revenues have shown relative stability, the composition of these revenues has undergone significant changes. This evolution is attributed to technological advancements and financial considerations, such as the availability of capital for new productions. The text specifically mentions the rise and subsequent relative decline of revenue from DVD and similar home media formats, alongside the growing importance of international markets. Therefore, an investor analyzing the film industry would need to consider these dynamic shifts in revenue sources when assessing investment opportunities, rather than relying on a static view of revenue generation.

The question tests the understanding of how risk premiums are calculated in real estate investment analysis, specifically concerning the choice of the risk-free rate maturity. The provided text highlights that while short-term rates are often used in other asset classes, the 10-year Treasury rate is typically employed in U.S. real estate. This is because the longer maturity of the 10-year Treasury is considered a better proxy for the typical holding period of real estate assets, thus more accurately reflecting the duration of interest rate risk exposure. Using a shorter-term rate would not adequately capture the long-term nature of real estate investments and the associated interest rate sensitivity.

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 an investor’s commitment to contribute capital. Therefore, the LPA is the most comprehensive document defining the fund’s structure.

The passage highlights the cyclical nature of investor sentiment towards quantitative investing, particularly after the “quant meltdown” of August 2007. It emphasizes that prolonged success and “crowding” in certain quantitative strategies can lead to significant, accumulating risks, potentially culminating in a “meltdown.” This inherent risk, coupled with a desire for proprietary advantage, explains investor aversion to “black box” strategies and manager aversion to transparent systems that competitors can easily replicate. Therefore, understanding these accumulating risks and the potential for a “meltdown” is a key takeaway for investors.

The question probes the understanding of the primary purpose of an offering document in the context of hedge fund investments. While it serves as a marketing tool and provides a summary of key investment details, it is not the legally binding document that governs the fund’s operations. The subscription agreement, for instance, is the legally operative document for an investor’s commitment. Therefore, characterizing the offering document as the definitive legal instrument for the fund’s structure and operations would be inaccurate.

The core concept here is the distinction between anticipated and unanticipated inflation and their impact on asset returns. In an informationally efficient market, anticipated inflation is already priced into assets, meaning nominal returns adjust to maintain real returns. Therefore, anticipated inflation itself is not a driver of *additional* returns. Unanticipated inflation, however, represents a deviation from expectations. When realized inflation exceeds anticipated inflation, it can lead to a reassessment of future inflation expectations, which in turn can significantly impact asset prices and thus become a driver of returns, particularly for real estate where lease structures and financing costs can be sensitive to inflation shifts. The question tests the understanding that only the unexpected component of inflation is a primary driver of real estate 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 foundational work laid the groundwork for future growth and development in alternative investments.

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 an illusion 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 risk premium or a factor-based return.

The passage highlights that top-tier private equity teams often raise funds through word-of-mouth referrals and direct outreach, rather than relying on a broad solicitation of investment proposals. This proactive approach involves identifying and engaging with promising teams even before they begin their fundraising cycles. This strategy is crucial because established managers prioritize existing Limited Partners (LPs) for follow-on fund allocations due to the reduced cost and uncertainty associated with maintaining these relationships. New investors, especially those without a strong network or a history of long-term commitment, face significant barriers to entry.

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, particularly if the chosen CTA is large and diversified with a performance profile closely mirroring a benchmark. However, this approach concentrates risk on a single manager, potentially limiting the diversity of trading strategies employed. To mitigate these risks and achieve diversification, a portfolio of multiple CTAs is generally recommended. This diversification is crucial for managing idiosyncratic risk associated with individual managers and their specific trading models.

Kaldor’s definition of speculative stocks focuses on the difference between the actual quantity of a commodity held and the quantity that would be held if prices were expected to remain constant. This implies that any holdings beyond what is needed for stable price expectations are speculative. Working’s definition, conversely, defines hedging as any futures activity by those handling the physical commodity, with speculation being any activity that is not hedging. The question asks about the core distinction in Kaldor’s framework, which is the deviation from a stable price expectation. Therefore, the difference between actual holdings and those held under a constant price expectation is the defining characteristic of speculative stock according to Kaldor.

The question tests the understanding of the primary role of a Fund of Hedge Funds (FoF) in the investment landscape. FoFs act as aggregators, pooling investor capital and then allocating it across various underlying hedge funds. This diversification across strategies, managers, and styles is a core function. While FoF managers perform due diligence, risk monitoring, and reporting, these are all activities that support the primary goal of diversified allocation. Simply investing in a single hedge fund or directly managing a portfolio of assets are functions of single-manager hedge funds, not FoFs. Therefore, the most accurate description of an FoF’s fundamental purpose is to provide diversified exposure to multiple hedge funds.

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 industrial/office sector is one such classification, and it is further broken down into three distinct subsectors. This detailed segmentation allows investors to track performance within specific niches of the commercial real estate market.

The NCREIF National Property Index (NPI) is a prime example of an appraisal-based real estate index. Appraisal-based indices rely on periodic professional valuations of properties rather than actual transaction prices. This method is employed due to the inherent illiquidity of real estate, where properties do not trade frequently enough for transaction-based calculations to be reliable, especially for short-term return estimations. The NPI specifically uses quarterly appraisals to determine property values and subsequently calculate income and capital returns. While transaction-based indices use actual sale prices, and hedonic models use statistical techniques to impute value based on property characteristics, and repeat-sales indices track the price changes of properties that have transacted more than once, the NPI’s methodology is fundamentally rooted in appraisals.

The distribution waterfall in private equity dictates the order in which profits are allocated. After the Limited Partners (LPs) have received their initial capital back, they are entitled to a preferred return, often referred to as the ‘hurdle rate.’ Once this preferred return is met, a ‘catch-up’ phase occurs, where the General Partner (GP) receives a disproportionately larger share of distributions until they reach their agreed-upon profit share (e.g., 20% of total profits). After the catch-up is complete, remaining profits are split according to the agreed-upon carried interest ratio (e.g., 80% to LPs and 20% to GP). Therefore, the catch-up zone is the period where the GP receives distributions to bring their profit share up to the agreed-upon percentage of the total profits generated above the preferred return.

This question tests the understanding of how commodity futures are used to hedge against price fluctuations in a producer’s input costs. An airline’s primary fuel cost is jet fuel. Therefore, to hedge against the negative impact of rising jet fuel prices on its profit margins, an airline would benefit from owning call options on jet fuel. Owning a call option gives the holder the right, but not the obligation, to buy jet fuel at a specified price (the strike price) before the option expires. If the market price of jet fuel rises significantly above the strike price, the airline can exercise its option to buy at the lower strike price, effectively capping its fuel costs. Conversely, buying put options would protect against a price decrease, which is not the primary concern for hedging against rising costs. Selling futures or options would expose the airline to the very price volatility it seeks to mitigate.