Alternative Investments. 12 question(s) in this unit's pool
(2 above the exam). Free up to ten a day; the coach picks which ones based on what you have
already answered and when each is next due.
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
explanation. Questions you have already answered correctly and confidently stay out of the way until they
are due for review again.
Question 1Exam level
A hedge fund begins the year with a NAV of $100 million. During the year, it earns a gross return of 25%, so NAV rises to $125 million. The fund charges a 2% management fee (on beginning NAV) and a 20% performance fee. No high-water mark applies. The total fee paid to the manager is closest to:
B. You might calculate only the performance fee ($5M) and forget the management fee. Management fee is always charged regardless of performance. It is charged on AUM, not on profits.
C. You might calculate only the management fee (2% × $100M = $2M). Performance fee is also owed because the fund earned a positive return above the hurdle (no hurdle stated in this case).
Unit: hedge-funds
Question 2Exam level
Which hedge fund strategy is most likely described as 'market-neutral'?
How sure are you?
Correct: B. Market-neutral means the strategy has no net exposure to broad market movements (beta ≈ 0). Long/short equity can be structured market-neutral by perfectly offsetting long and short positions. Global macro takes directional bets on macro variables (not neutral). Merger arb has deal-specific risk (not market neutral per se, though it has low market beta). Managed futures follows trends.
A. Global macro sounds 'neutral' because it spans many markets. Global macro takes explicit directional bets on currencies, rates, equities, commodities. Highly directional.
C. Merger arb profits are largely independent of broad market direction, so candidates confuse 'low market beta' with 'market neutral'. Merger arb is event-driven and exposed to deal-specific risk, not a true market-neutral strategy.
Unit: hedge-funds
Question 3Exam level
An investor wants to redeem her investment in a hedge fund but is told she can only receive 60% of her requested amount this quarter, with the remaining 40% returned over the next two quarters. This restriction is most likely described as a:
How sure are you?
Correct: B. A gate provision limits the percentage of total fund AUM that can be redeemed in any given period, to prevent fire-sale liquidations. The investor CAN redeem, but only partially. A lockup period prevents ANY redemption for an initial period. A redemption notice period requires advance notice (e.g., 90 days) but does not limit the amount. A clawback reclaims previously paid performance fees.
A. Both lockup and gates restrict redemption. You might confuse their mechanisms. Lockup prevents redemption entirely for a fixed initial period. Gates restrict the AMOUNT that can be redeemed in a period, not whether any redemption is allowed.
C. Redemption notice is a timing restriction on when you can redeem. Redemption notice only specifies when (how far in advance you must notify), not how much you can redeem.
Unit: hedge-funds
Question 4Harder
A hedge fund following a 'relative value' strategy would MOST LIKELY:
How sure are you?
Correct: B. Relative value strategies exploit pricing discrepancies between related or similar securities. E.g., the yield spread between a corporate bond and its theoretical fair value, or the price relationship between a convertible bond and its underlying equity. LTCM is the classic case: they bet on convergence of off-the-run vs on-the-run Treasury spreads.
A. This sounds like relative value because it involves buying AND selling simultaneously. This describes market-neutral long/short equity, which is a sub-strategy of long/short equity, not relative value. Relative value focuses on pricing discrepancies, not equity factor exposure.
C. Merger arb also involves simultaneous positions. Merger arb is event-driven, not relative value. It profits from deal completion, not price convergence.
Unit: hedge-funds
Question 5Exam level
Which of the following BEST describes the purpose of a high-water mark in a hedge fund fee structure?
How sure are you?
Correct: B. The HWM ensures that performance fees are only earned when the fund is at an all-time high NAV. If the fund loses value, the manager earns no performance fee until NAV recovers past the previous HWM. This aligns manager incentives with investor interests. The manager must recover losses before earning new incentive compensation.
A. The HWM does protect investors from double-paying fees after losses. HWM doesn't limit management fees. It only affects performance fees. Management fees are charged on AUM regardless of performance.
C. This sounds similar to a clawback provision. A clawback requires return of PREVIOUSLY PAID performance fees in certain circumstances, not personal reimbursement for fund losses. HWM simply prevents new performance fees from accruing until NAV recovers.
Unit: hedge-funds
Question 6Harder
Long Term Capital Management (LTCM) collapsed in 1998 primarily due to risks associated with which hedge fund strategy, most likely?
How sure are you?
Correct: B. LTCM employed fixed income relative value strategies. Primarily betting on convergence between on-the-run and off-the-run US Treasury yields, and similar spread convergence trades across global fixed income markets. When Russia defaulted in 1998 and the market flight-to-quality caused spreads to WIDEN (not converge), LTCM's highly leveraged positions suffered catastrophic losses. The key lesson: relative value strategies assume convergence but can suffer when correlations break down under stress.
A. LTCM had global positions across many countries, resembling global macro. LTCM's positions were spread-convergence bets, not directional macro bets on currencies, rates, or commodity prices. The strategy was relative value, not macro.
C. You might be tempted by long/short equity because it involves betting on the relative performance of stocks, but LTCM's failure stemmed from fixed income arbitrage, not equity market bets, highlighting the specific risk in assuming convergence in bond spreads.
Unit: hedge-funds
Question 7Exam level
An activist hedge fund acquires a 9.5% stake in a publicly traded company and publicly demands the board replace the CEO and initiate a share buyback. This is most likely classified as:
How sure are you?
Correct: B. Activist investing is a sub-strategy of event-driven investing. The fund deliberately creates a corporate event (management change, buyback, spin-off) to unlock value. Pershing Square Capital Management (Bill Ackman) is the classic example. Taking stakes in companies like Canadian Pacific and Herbalife and pushing for change. This is distinct from merely buying and holding undervalued equities (long/short equity).
A. The fund is buying equity (going long), which resembles long/short equity. Long/short equity profits from price movements in equities. Activist investing CREATES the catalyst for price movement through shareholder engagement. The mechanism is fundamentally different.
C. You might be tempted by relative value: equity arbitrage because it involves exploiting price differences between related securities, but this strategy does not involve the active engagement with the company management and governance changes that characterize activist investing.
Unit: hedge-funds
Question 8Exam level
Which of the following hedge fund strategies has historically shown the LOWEST correlation to equity markets, most likely?
How sure are you?
Correct: C. Market-neutral long/short equity (zero net exposure, beta ≈ 0) by construction has near-zero correlation to the equity market. The fund profits from relative performance of long vs short positions, not market direction. A net-long 70% long/short fund (A) retains significant market beta. Global macro (B) can be negatively correlated with equities depending on the macro bet. Merger arb (C) has low but positive market correlation.
A. Global macro focuses on currencies and bonds, not equities, so seems uncorrelated. Global macro still takes directional bets and can be highly correlated with equities depending on the specific positions and macro environment. It is not designed to be market-neutral.
B. You might be tempted by merger arbitrage because it involves taking advantage of price discrepancies in mergers, which seems uncorrelated, but it actually has a low positive market correlation due to its exposure to market conditions, unlike the near-zero correlation of market-neutral long/short equity.
Unit: hedge-funds
Question 9Harder
A hedge fund manager received $10 million in performance fees last year. Due to a clawback provision in the limited partnership agreement, which condition would MOST LIKELY trigger the return of some of these fees?
How sure are you?
Correct: B. Clawback provisions require managers to return previously earned performance fees if investors ultimately realize losses. Most commonly if the fund is wound down with cumulative losses relative to investor initial capital, even if some years were profitable. The purpose is to prevent managers from keeping fees earned in good years when the fund ultimately loses money for investors.
A. HWM and clawback both relate to performance fee fairness, so candidates conflate them. Falling below HWM prevents NEW performance fees from being earned. It does not require returning fees already received. Clawback specifically requires returning PREVIOUSLY PAID fees.
C. You might be misled by thinking that management fees relate to clawback provisions, but management fees are a fixed percentage of AUM and do not trigger clawbacks, which are specifically tied to performance fees and investor losses as in choice B.
Unit: hedge-funds
Question 10Exam level
Compared to long-only equity mutual funds, hedge funds typically most likely have which of the following characteristics?
How sure are you?
Correct: A. Hedge funds charge 2% management fees + 20% performance fees vs ~0.5-1% for mutual funds (higher fees). They impose lockups and gates limiting redemption (lower liquidity). They report to accredited investors only, not publicly, and are not required to disclose holdings (less transparency). This characteristic trio distinguishes hedge funds from traditional long-only vehicles.
B. You might correctly identify higher fees but incorrectly assume hedge funds are more liquid because they can invest globally and trade frequently. Trading frequency of the fund is not investor liquidity. Investors face lockup periods, gate provisions, and quarterly/annual redemption windows. Far less liquid than daily-redeemable mutual funds.
C. You might be tempted by lower fees and more transparency, thinking these align with regulatory trends, but hedge funds actually charge higher fees and offer less transparency compared to mutual funds, making choice C incorrect.
Unit: hedge-funds
Question 11Above the exam
A hedge fund's Year 1 NAV falls from $100 to $80 per unit (below the high-water mark set at inception, $100). In Year 2, the fund rises to $95 per unit. In Year 3, the fund rises further to $115 per unit. Combining the high-water mark provision with a 20% incentive fee, the incentive fee earned in Year 3 (per unit) is closest to:
How sure are you?
Correct: A. The high-water mark requires the fund to exceed its PRIOR PEAK NAV ($100, set at inception) before any NEW incentive fee is earned, regardless of how much the fund fell in between. By the end of Year 3, NAV of $115 exceeds the $100 high-water mark by $15; the incentive fee = 20% x $15 = $3.00 per unit. The Year 2 recovery from $80 to $95 earned no fee at all (still below the $100 high-water mark); only the portion of Year 3's gain that pushes NAV above the original $100 peak is fee-eligible.
B. Applying the fee to the full Year 2-to-Year 3 gain ($95 to $115 = $20) ignores that part of that gain (from $95 back up to $100) simply RECOVERS the fund back to its already-set high-water mark and is not a new incentive-fee-eligible gain; only the amount ABOVE the $100 high-water mark ($15, from $100 to $115) is fee-eligible.
C. The fund DID exceed its high-water mark during Year 3 (ending at $115, above the $100 mark), which does trigger a fee on the portion above $100; concluding no fee is earned at all ignores that the fund's Year 3 ending NAV clearly surpassed the high-water mark.
Unit: hedge-funds
Question 12Above the exam
An investor compares two hedge fund strategies: Strategy X, a market-neutral long/short equity fund (target beta near zero), and Strategy Y, a global macro fund that took a large directional bet against a specific currency this year. Combining each strategy's typical source of return with the concept of correlation to broad equity markets, during a year when equity markets fall sharply, the investor should most likely expect:
How sure are you?
Correct: B. A market-neutral long/short equity strategy is specifically constructed to have near-zero net exposure to overall market direction (long and short positions largely offsetting broad market moves), so it should be relatively insulated from a broad equity sell-off, profiting or losing based on relative stock selection instead. A global macro strategy's returns depend on the specific bets the manager makes (here, a currency bet), which are largely UNRELATED to the direction of the equity market; its performance in an equity downturn depends on how that particular currency bet performs, not on equity market direction itself.
A. Different hedge fund strategies are specifically designed to have very different relationships to broad market risk; assuming they all carry similar market risk ignores the entire premise of strategy classification (market-neutral vs. directional/macro) this LOS teaches.
C. Hedge funds are not universally designed to profit during market declines; only strategies specifically constructed with low or negative market correlation (like market-neutral long/short) are relatively insulated, and even those are not guaranteed to rise, they aim to be independent of market direction, not automatically profitable when markets fall.