Alternative Investments — CFA Level II practice questions

Hedge fund strategies include:

1. Long/short equity in this context
2. Trade-off theory optimal leverage
3. Share repurchase accretive result
4. Residual dividend policy outcome

Answer: A — Long/short equity in this context

A) Correct — this identifies Long/short equity in this context. B) Trade-off theory optimal leverage — related concept, not the definition. C) Share repurchase accretive result — related concept, not the definition. D) Residual dividend policy outcome — related concept, not the definition.

A hedge fund's IRR is often a POOR measure of investor experience because:

1. IRR depends on the size and timing of cash flows, which the fund manager can influence through the timing of capital calls and distributions
2. IRR and time-weighted return always produce identical values regardless of cash flow timing
3. IRR is unaffected by intermediate cash flows once the fund is fully invested
4. IRR always understates the investor's actual realized return

Answer: A — IRR depends on the size and timing of cash flows, which the fund manager can influence through the timing of capital calls and distributions

A) Correct — because IRR is a dollar-weighted measure, it's sensitive to the size and timing of cash flows, which the manager largely controls through capital call and distribution timing. B) Common misconception — IRR and time-weighted return diverge whenever cash flows occur at different times relative to fund performance. C) Incorrect — IRR remains sensitive to every cash flow's timing and size throughout the fund's life. D) Incorrect — IRR can overstate or understate the investor's experience depending on cash flow timing.

An investor holds a fully collateralized long position in a commodity futures contract. Over the period, the spot price return is +3%, the futures curve is in contango generating a roll yield of −4%, and the collateral (T-bill) yield is +2%. The total return on the fully collateralized position is closest to:

1. +9%, summing the absolute values of all three components regardless of sign
2. −1%, reversing the sign of the collateral yield, treating it as a cost rather than a yield
3. +5%, omitting the roll yield component and summing only the spot return and collateral yield
4. +1%, summing the spot return, roll yield, and collateral yield with their respective signs

Answer: D — +1%, summing the spot return, roll yield, and collateral yield with their respective signs

A) Sums the magnitudes without regard to the negative sign on roll yield, overstating total return. B) Flips the sign on the collateral yield, which is a genuine positive component of a fully collateralized futures position (the return on the posted collateral), not a cost. C) Omits the roll yield entirely — a common oversight that ignores the real, and here negative, drag that contango imposes on a long futures position. D) Correct — total return ≈ spot return + roll yield + collateral yield = 3% + (−4%) + 2% = +1%.

A commodity futures curve is in steep backwardation, with the expiring near-month contract priced above longer-dated contracts. An investor holding a long position who rolls from the expiring contract into the next-dated contract will realize:

1. A negative roll yield, since the near-month contract's price erodes as it approaches expiration
2. No roll yield effect, because roll yield applies only to short futures positions
3. A positive roll yield, from selling the higher-priced expiring contract and buying the lower-priced further-dated contract
4. A positive roll yield only if the spot price also rises over the holding period

Answer: C — A positive roll yield, from selling the higher-priced expiring contract and buying the lower-priced further-dated contract

A) This confuses convergence of futures to spot at expiration with the roll itself; roll yield depends on the curve's shape, not price erosion near expiry. B) Roll yield applies to both long and short positions, just with opposite signs. C) Correct — in backwardation, the long investor sells the pricier near-month contract and buys the cheaper deferred contract, capturing a positive roll yield. D) Roll yield arises from the shape of the futures curve and is realized independent of whether spot itself subsequently rises.

Commodity futures total return decomposes into spot, roll yield, and collateral yield. In a steeply backwardated market, the LONG investor's expected return is BOOSTED MOST by:

1. Direct capitalization NOI over rate
2. Direct lending floating-rate credit
3. Brownfield concession-based revenue
4. Positive roll yield from rolling

Answer: D — Positive roll yield from rolling

A) Direct capitalization NOI over rate — related concept, not the definition. B) Direct lending floating-rate credit — related concept, not the definition. C) Brownfield concession-based revenue — related concept, not the definition. D) Correct — this identifies Positive roll yield from rolling expiring contracts.

A private equity fund's distribution waterfall provides LPs an 8% preferred return, followed by a 100% GP catch-up, then an 80/20 LP/GP split. LPs have just received their full $8.0M preferred return on $100M of contributed capital, and exactly $2.0M of additional profit — the full catch-up tranche needed for the GP to reach 20% of profits distributed to date — is now available. Of this $2.0M, the GP is entitled to receive:

1. 100% ($2.0M), since the catch-up clause directs all profit to the GP until it has received 20% of total profits distributed
2. 80% ($1.6M), consistent with the standard post-catch-up profit split
3. 20% ($0.4M), since GP carried interest is capped at 20% of any single distribution
4. $0, because catch-up only applies once LPs separately recover a full return of capital beyond the preferred return

Answer: A — 100% ($2.0M), since the catch-up clause directs all profit to the GP until it has received 20% of total profits distributed

A) Correct — under a 100% catch-up, the GP receives the entire tranche until its cumulative share equals 20% of profits distributed to date; here that tranche is exactly $2.0M. B) The 80/20 split applies only after the catch-up tranche is fully paid, not during it. C) This confuses the ultimate 20% carry rate with the catch-up mechanic, which pays the GP 100% (not 20%) of this tranche. D) The preferred return already represents the LPs' priority return; the catch-up is the very next tier and does not require a separate capital-recovery step.

Real estate valuation methods:

1. Roll yield in contango negative
2. Greenfield build-out phase risk
3. Income approach in this context
4. Cap rate expansion lowers value

Answer: C — Income approach in this context

A) Roll yield in contango negative — wrong roll-yield direction. B) Greenfield build-out phase risk — related concept, not the definition. C) Correct — this identifies Income approach in this context. D) Cap rate expansion lowers value — direction reversal.

A real estate property has NOI of $500,000 and trades at a market cap rate of 6%. Its market value is approximately:

1. $9.16M per calc approx
2. $8.33 million per calc
3. $7.50M per calc approx
4. $10.00M per calc est.

Answer: B — $8.33 million per calc

A) $9.16M per calc approx — off-by-percent numeric trap. B) Correct — the computed value is $8.33 million. C) $7.50M per calc approx — off-by-percent numeric trap. D) $10.00M per calc est. — off-by-percent numeric trap.

A venture capital fund reports, at year 6, a DPI of 0.4× and an RVPI of 1.3×. A secondary-market buyer offers to purchase an LP's fund interest at a price implying a 1.5× TVPI. The LP should recognize that this offer:

1. Represents a premium to the fund's reported TVPI, since DPI already reflects cash actually returned
2. Is irrelevant, because secondary-market pricing does not consider fund-level performance metrics
3. Exactly matches the fund's reported TVPI, so the LP should be indifferent between selling and holding
4. Represents a discount to the fund's reported TVPI of 1.7× (0.4 + 1.3), consistent with the illiquidity and valuation uncertainty of the unrealized (RVPI) portion

Answer: D — Represents a discount to the fund's reported TVPI of 1.7× (0.4 + 1.3), consistent with the illiquidity and valuation uncertainty of the unrealized (RVPI) portion

A) TVPI sums DPI and RVPI (0.4 + 1.3 = 1.7×), so 1.5× is below, not above, the reported multiple. B) Secondary buyers routinely price off reported DPI/RVPI/TVPI, applying a discount for illiquidity and NAV uncertainty. C) 1.5× does not equal the reported 1.7× TVPI — the offer is below it. D) Correct — reported TVPI is 1.7×; a 1.5× offer reflects a discount appropriate for the unrealized, harder-to-verify RVPI component.

A direct lending fund originates a floating-rate loan at SOFR + 550 bps, charges a 100 bps upfront origination fee (amortized straight-line over the loan's 4-year term), and charges investors a 1% annual management fee on invested capital. SOFR is currently 4.50%. All of the following statements about this loan's yield economics are correct EXCEPT:

1. The loan's coupon rate is 10.00% (SOFR of 4.50% plus the 550 bp spread)
2. The amortized origination fee adds approximately 25 basis points per year to the lender's gross yield
3. The loan's gross yield, excluding the management fee, is approximately 10.25%
4. The lender's net yield after deducting the 1% management fee is higher than its gross yield before fees

Answer: D — The lender's net yield after deducting the 1% management fee is higher than its gross yield before fees

A) True — coupon = SOFR + 550 bps = 4.50% + 5.50% = 10.00%. B) True — a 100 bp fee amortized over 4 years adds 25 bps per year to the annualized gross yield. C) True — gross yield ≈ 10.00% coupon + 0.25% amortized fee = 10.25%. D) Correct (the exception) — a management fee is a cost that reduces the lender's (investor's) net yield relative to gross; it can never make net yield higher than gross yield, so this statement is false.

What is the GP catch-up provision in a private equity distribution waterfall?

After LPs receive their preferred return, the catch-up directs most or all (often 100%) of subsequent distributions to the GP until the GP's cumulative share equals its stated carried-interest percentage of total profits — after which the standard split (e.g., 80/20) resumes.

What is the J-curve effect?

Following currency depreciation, the trade balance worsens before improving (because contracted import prices rise immediately, while export volumes adjust slowly).

What are the major categories of alternative investments?

Hedge funds, private equity (VC, buyout, growth), real estate, infrastructure, commodities, natural resources, collectibles. Less liquid, often less regulated.

What is survivorship bias in hedge fund returns?

Reported indices include only surviving funds; failed funds drop out, biasing reported returns upward. Backfill bias compounds the issue.