CAIA level 1 - Topic 2 Introduction to alts Exam Questions & Answers

4 types of alternative assets - Answer Alternatives are defined by inclusion: Real Assets Hedge Funds Private Equity Structred products Real Assets - Answer Direct ownership of non financial assets: - natural resources - commodities - real estate - land - infrastructure - IP (intellectual property) 5 Structures of Alternatives - Answer TRICS: - trading - marked by high skill & complex strategy (hedge fund) - regulatory - marked by lower government regulation and taxation ( - institutional - private & non-retail markets - compensation - performance based fee & incentive structure - securities - unlike traditional equity & debt cash flow structure Structures of Real assets - Answer Institutional Securities Regulatory Compensation Hedge Funds - Answer Privately organized investment vehicles with little regulation - involved shorting, leverage or derivatives - includes managed future Private equity - Answer Equity and debt positions which are not publicly traded - venture capital - LBOs - mezzanine debt - distressed debt Structured Products - Answer Instruments created to exhibit particularly return, risk, taxation, or other attribute - include CDOs and credit derivatives Return characteristics of alternatives - Answer NIDI Non-normality - do not follow bell curve (not easily modeled or predicted) Illiquidity - investment trades infrequently and/or with low volume; often nondivisible lumpy assets Diversifiers - low correlation with traditional assets; absolute return products Inefficiency - market prices do not reflect all available information; may lead to superior risk-adjusted performance Methods of analysis - Answer RSVP - return computation - use cash flows due to lack of market values - statistical - incorporate the non-normality of returns - valuation - incorporate evaluation of fund managers, investment illiquidity, unique cash flows & appraised valuation - portfolio management - address non-normality and illiquidity Other factors of alternatives - Answer 3is Information asymmetries Incomplete market Innovation 4 goals of alternatives - Answer - active management (outperform benchmark) - arbitrage - simultaneous long and short relative value positions - return enhancement - increasing average returns - return diversifier - focus on decreasing risk Absolute return standard - Answer Returns are evaluated independently of market, usually against zero or risk less rate Relative return standard - Answer Returns are evaluated relative to benchmark linked to markets Active risk - Answer Risk that causes portfolio's return to deviate from benchmark return due to active management Lumpy assets - Answer Assets that can only be bought or sold in specific quantities (large real estate holdings) Moral hazard - Answer Risk that behavior of one or more parties changes after entering into a contract Operationally focused real assets - Answer Require higher level of management: real estate, land, infrastructure, intellectual property (vs commodities) 3 types of market participants - Answer Buy side - institutional asset owners: plan sponsors, foundations, endowments, family office, private wealth, sovereign wealth, LPs, private Invesment pools, 40 act funds, MLPs Sell side - institutional asset sellers: large dealer banks, brokers Outside service providers: primate brokers, accountants, auditors, attorneys, hedge fund, consultants, commercial banks Buy side - Answer institutional asset owners: plan sponsors, foundations, endowments, family office, private wealth, sovereign wealth, LPs, private Invesment pools, 40 act funds, MLPs Sell Side - Answer institutional asset sellers: large dealer banks, brokers Types of financial Markets - Answer Primary Secondary Third (private) Fourth (private) Primary market - Answer IPOs & secondary issues - investors buy securities directly from issuers corporations or directly from government (treasuries) Secondary market - Answer Also called aftermarket or follow-on public offering where investors can buy from other invdestors Physical exchange - network of dealers such as New York Stock Exchange, London Stock Exchange, Nasdaq Provide a centralized, liquid secondary market for investors who own stocks Third market (private) - Answer Regional exchanges where secondary market securities - known as OTC - institutions trade blocks of securities directly Fourth market (private) - Answer Electronic communication networks - high frequency trading, Dark pools, ATS (alternative trading systems), MTF (multilateral trading facilities) 'Investment company act of 1940 - 40 Act Funds - Answer Instituted to regulate investment pools, Registered (regulated) funds, often called mutual funds; hedge funds often utilize exemptions to avoid registration Securities Act of 1933 - Answer Governs new securities issues and requires the company to disclose relevant information, register new issues and disseminate a prospectus Investment advisors act 1940 - Answer Requires investment advisers register with the SEC also subjects advisers to anti fraud regulations 5 types of liquid alternatives - Answer Utilize private placement investment within retail fund - regulated constraints include leverage, diversification, liquidity - skill-based replication - liquidity-based: use liquid investments having similar characteristics to illiquid securities - constrained clones: attempt to follow similar strategy as existing alternative investment product - unconstrained clones: attempt to follow near-identical of an existing alternative investment that s relatively liquid - diversified / absolute return products: focus on creating returns that have low correlation with traditional investments but not patterned on existing alts 4 performance factors responsible for the difference in Liquid alts vs private placement liquid alts - Answer No incentive fees - lower fees Less skilled managers Inability to capture illiquidity premiums Narrower set of permissible investment strategies