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Introduction to Alternative Investments (Reading 66)


Exercise Problems:


1. Which of the following most likely trades in the secondary markets?

A. Open-end funds

B. Closed-end funds

C. Unit investment trusts



Ans: B;


B is correct because closed-end funds trade in the secondary markets and do not offer a redemption feature.

2. Which of the following is least likely a reason for discounting the value of stock in a closely held company?

A. Illiquidity

B. Marketability

C. Controlling interest


Ans: C;


C is a correct because company control would increase the value of the closely held company or add a premium.

3. An analyst is evaluating an investment in an apartment complex based on the following annual data:

Gross potential rental income

$2,100,000

Estimated vacancy and collection expenses

3%

Operating expenses

$1,600,000

Depreciation

300,000

Current mortgage rate

5%

Financing percentage

80%

Market capitalization rate

12%

Cost of equity

15%

Based on the income approach, the value of the investment is closest to:

A. $1,141,667.

B. $3,641,667.

C. $6,242,857.



Ans: B;


B is correct because using the income approach, ($2,100,000 – .03 × $2,100,000 – $1,600,000)/0.12 = $437,000/0.12 = $3,641,667. The property is appraised based on cash flows and is independent of the financing decision. Thus, the market capitalization rate is used rather than the lending rate. Depreciation is also not deducted because it is implicitly assumed that repairs and maintenance allow the investor to keep the building in good condition.

4. Which of the following statements regarding biases in hedge fund performance in hedge fund databases is least likely correct?

A. Only hedge fund managers with good track records enter the database, creating a positive bias.

B. The correlations between asset class returns are artificially low when underlying assets trade infrequently.

C. Hedge fund database administrators decide which funds to include in the database to overcome self-selection bias.


Ans: C;


C is correct because hedge fund managers themselves, not database administrators, decide whether they want to be included in a database. Managers who have funds with an unimpressive track record will not wish to have that information exposed.


5. A project that requires an initial investment of 5 million is expected to pay 22 million at the end of five years if it is successful. The probabilities of failure for the project are provided below:

Year

1

2

3

4

5

Failure Probability

0.25

0.20

0.15

0.15

0.15

Assuming the cost of capital for the project is 16%, the project’s expected net present value is closest to:

A. –3,157,000.

B. –1,140,000.

C. 2,017,000.





Ans: C;


B is correct because you calculate the probability of success as (1 – .25) × (1 – .20) × (1 – .15) × (1 – .15) × (1 – .15) = 0.3685. Then, calculate the NPV from success as [(22,000,000/1.16^5) – 5,000,000] × 0.3685 = 2,017,000. The NPV of failure is –5,000,000 × (1 – .3685) = –3,157,000. The expected NPV of the project is 2,017,000 – 3,157,000 = –1,140,000.

6. Which of the following least likely describes an advantage of investing in hedge funds through a fund of funds? A fund of funds may provide investors with:

A. lower fees due to economies of scale.

B. access to funds that are closed to new investors.

C. access to managers with expertise in finding reliable and good-quality hedge funds.



Ans: A;


A is correct because the fees on funds of funds are usually higher. The fund of funds manager charges a fee, and there is a fee charged by each hedge fund.


7. Compared with investment in an open-ended index mutual fund, which of these is least likely a benefit to an investor in an index exchange traded fund (ETF) on the same index?

A. Lower bid–ask spreads

B. Managing the timing of capital gains

C. Ability to sell short and buy on margin



Ans: A;


A is correct because open-ended mutual fund shares are created and redeemed at net asset value with no bid–ask spread, whereas ETFs trade like stocks with a bid–ask spread.


8. Which of the following is least likely an aggregation vehicle for real estate ownership?

A. Leveraged equity rights

B. Real estate investment trusts (REITs)

C. Real estate limited partnerships (RELPs)



Ans: A;


A is correct because leveraged equity rights is not an aggregation vehicle. Leveraged equity does not give investors collective access to real estate investments.


9. Do base management fees most likely get paid to the manager of a hedge fund regardless of the fund’s performance?

A. Yes

B. No, only when the fund’s gross return is positive

C. No, only when the fund’s net asset value exceeds the previous high water mark



Ans: A;


A is correct because the base management fee is always paid to the fund manager regardless of performance.


10.An office building with net operating income of $75,000 recently sold for $937,500. Financial data for a comparable building that is currently on the market for sale is presented in the table below.

Annual income or expense

Gross potential rental income

$300,000

Estimated vacancy and collection losses

4%

Insurance and taxes

$27,000

Utilities

$14,000

Repairs and maintenance

$21,000

Depreciation

$15,000

Interest rate on proposed financing

7%

The estimated value for the building being sold using the income approach is closest to?

A. $2,825,000.

B. $2,975,000.

C. $3,228,500.



Ans: A;


A is correct because to arrive at the estimated value of the property, subtract operating expenses from gross income (300,000 – (4% *300,000 or 12,000) – 27,000 – 14,000 – 21,000 = 226,000). Then divide the net operating income by the cap rate which is derived from the recent transaction (226,000/(75,000/937,500) = 226,000/.08 = 2,825,000). Note that neither depreciation nor financing costs are deducted as operating expenses.

11.An investor in exchange traded funds (ETFs) is most likely to benefit from its:

A. end of day pricing.

B. lack of tracking error risk.

C. lower capital gains tax liability relative to mutual funds.



Ans: C;


C is correct because the capital gain distribution is lower for ETFs than for mutual funds as sales of the underlying securities are not necessary to accommodate inflows/outflows as securities are transferred in kind to investors.


12.Which of the following statements is least likely an advantage of investing in hedge funds through a fund of funds? Funds of funds provide:

A. an increase in expected return through diversification.

B. expertise in selecting funds and conducting due diligence.

C. access to successful funds that may otherwise be closed to new investors.







Ans: A;


A is correct because diversification results in risk reduction, not return enhancement. Further, the fees charged by the fund of funds manager will likely reduce returns relative to direct hedge fund investment.

13.An index provider has created a new investable index that tracks the hedge fund industry. Any fund that follows a long/short equity strategy can enter the index. The index provider places new constituents in the index at the end of each year and incorporates the new funds’ track record in the database. Which of the following is least likely a bias that might distort the historical performance of the index?


A. Backfilling.

B. Self-selection.

C. Tracking error.



Ans: C;


C is correct because this is not a bias that is associated with distorting the performance of a hedge fund index. Tracking error is a risk more commonly associated with mutual funds and ETFs when their investments deviate significantly from those in the index it is benchmarked against. Many hedge funds pursue absolute returns and may deviate materially from indices.


14.One advantage of exchange traded funds relative to open-end mutual funds is:

A. they trade throughout the day.

B. they offer greater diversification.

C. they have smaller bid-ask spreads.



Ans: A;


A is correct. Exchange traded funds trade throughout the trading day at market prices that are updated continuously, rather than only trading once a day at closing market prices, as do the traditional open-end mutual funds.


15.A fund manager is compensated with a base management fee plus an incentive fee proportional to the fund’s return above a benchmark. This best describes the fee structure of:

A. a hedge fund.

B. a mutual fund.

C. an exchange traded fund.



Ans: A;


A is correct. A hedge fund manager is compensated through a base management fee based on the value of the assets under management plus an incentive fee proportional to the fund’s return above a benchmark.


16.The real estate valuation approach that uses a perpetuity discount type model is the:

A. cost approach.

B. income approach.

C. sales comparison approach.



Ans: B;


B is correct. The income approach to real estate valuation values a property using a perpetuity discount type of model.


17.A fund that calculates net asset value by subtracting liabilities from assets and dividing the result by a fixed number of shares is most likely:

A. a hedge fund.

B. an open-end mutual fund.

C. a closed-end mutual fund.



Ans: C;


C is correct. Closed-end mutual funds calculate NAV as follows: NAV = (Assets – Liabilities)/Number of shares Outstanding


18.Which classification of hedge funds is least likely to use a short position in stock as a part of its strategy?

A. Market-neutral funds.

B. Emerging-market funds.

C. Distressed securities funds.



Ans: B;


Emerging-market funds invest in less liquid and less efficient assets of emerging markets that are difficult to short.


19.When comparing investing in exchanged traded funds (ETFs) to investing in open-end mutual funds, which of these is most likely not an advantage of ETFs? ETFs:

A. provide lower exposure to taxes related to capital gains distribution.

B. trade throughout the entire trading day at market prices that are continuously updated.

C. are a more cost effective way for large institutional investors to invest in less liquid markets.



Ans: C;


Some sector and international ETFs have large bid-ask spreads and substantial expense ratios compared to managed portfolios, which may provide a more cost efficient alternative to ETFs, particularly for large institutional investors.


20.Venture capital investments used to provide capital for companies initiating commercial manufacturing and sales are most likely to be considered a form of:

A. first-stage financing.

B. mezzanine financing.

C. second-stage financing.



Ans: A;


Venture capital investments provided to initiate commercial manufacturing and sales is considered a form of first-stage financing.


21.An analyst compared the performance of a hedge fund index with the performance of a major stock index over the past eight years. She noted that the hedge fund index (created from a database) had a higher average return, higher standard deviation, and higher Sharpe ratio than the stock index. All the successful funds that have been in the hedge fund database continued to accept new money over the eight-year period. What biases do the risk and return measures in the database most likely have? Average return:

A. and standard deviation are both overstated.

B. is overstated and standard deviation is understated.

C. is understated and standard deviation is overstated.



Ans: B;


Survivorship bias affects both the returns and the risk (standard deviation) reported for the hedge funds. Hedge funds with low or negative returns will be excluded from the index as will funds with high volatility; those funds will not survive for eight years. If only the successful funds remain in the index, the returns are overstated and risk is understated. Overstated returns and understated risk will both tend to overstate the Sharpe ratio.


22.An analyst estimates that an initial investment of ??500,000 in a venture capital project will pay ??6 million at the end of five years if the project succeeds and that the probability the project survives to the end of the fifth year is 25 percent. The required rate of return for the project is 19 percent. The expected net present value of the venture capital investment is closest to:

A. 128,000.

B. 1,125,000.

C. 2,014,000.



Ans: A;


The probability that the venture will pay 6 million at the end of five years is 25%. The probability of failure is 75%. The expected NPV if the project succeeds is 2,014,296 using FV = 6,000,000, I = 19%, n = 5 for a present value of 2,514,296 – 500,000 = 2,014,296. The NPV of the project is 0.25(2,014,296) + 0.75(–500,000) = ??128,574. The investment has a positive NPV and should be accepted.


23.An investor has gathered the following data, presented on an annual basis, for an apartment complex that is being considered for purchase:

Potential income (net of vacancy and collection losses )

$180,000

Insurance and taxes

$15,000

Utilities

$10,000

Repairs and maintenance

$18,000

Depreciation

$21,000

Interest on proposed financing

$16,000

The annual net operating income (NOI) for the apartment complex is closest to:

A. $116,000.

B. $121,000.

C. $137,000.



Ans: C;


NOI = $180,000 - $15,000 - $10,000 - $18,000 = $137,000.

24.A variation of which real estate valuation approach is most likely to use slope coefficients derived from a statistical analysis to estimate the value of a property?

A. Cost approach.

B. Income approach.

C. Sales comparison approach.



Ans: C;


One variation of the sales comparison approach (hedonic price estimation) uses recent transactions in the area to derive an equation that weights various property attributes to determine a value for the property.

25.Hedge funds that contain infrequently traded assets would most likely exhibit a downward bias with respect to:

A. measured risk but not correlations with conventional equity investments.

B. correlations with conventional equity investments but not measured risk.

C. both measured risk and correlations with conventional equity investments.



Ans: C;


The presence of infrequently traded assets leads to smoothed pricing that induces a significant downward bias to the measured risk of the assets as well as reducing the correlations of returns with conventional equity and fixed income returns.

26.A typical hedge fund fee structure is least likely to include a:

A. base fee.

B. high water mark.

C. negative incentive fee.



Ans: C;


C is correct because the fee structure can include a base fee and “high water mark” but not a negative performance fee. The lowest performance fee would be zero.

27.The infrequent trading of some assets that hedge funds invest in most likely results in hedge fund:

A. risk being understated.

B. returns being understated.

C. correlations with other assets being overstated.



Ans: A;


The infrequent trading of some assets held by hedge funds results in risk measures calculated on the basis of estimated fair value of holdings rather than market prices. This results in reduced volatility or risk.

28.Which of the following is the least accurate approach used to value closely held companies? Basing the value of company on the:

A. present value of future economic income.

B. historic cost of the assets of similar companies.

C. average market price of similar companies recently sold.



Ans: B;


This is not a method used to value closely held companies. The correct method is to base it on the replacement cost of the company’s assets.

29.The primary motivation for investing in commodity-linked bonds is that they most likely provide:

A. an income stream.

B. capital gains returns.

C. protection against interest rate risk.



Ans: A;


The primary reason for investing in commodity-linked bonds is that they provide the investor with an income stream.

30.Exchange Traded Funds (ETFs) are affected by trading risk, which is most likely to:

A. expose investors to counterparty credit risk.

B. result in prices that differ from Net Asset Value ( NAV).

C. provide investment results that do not correspond to the price and yield performance of their respective indexes.



Ans: B;


An ETF is designed to make it likely that it will trade close to its NAV. Impediments to the securities markets may result in trading prices that differ, sometimes significantly, from NAV. There is no assurance that an active trading market will always exist for the ETF on the exchange, so the bid-ask spread can be large for some ETFs.

31.When using the net income approach (NOI) in real estate valuation, if inflation is passed through, then the appraisal price will most likely:

A. increase.

B. decrease.

C. remain unchanged.



Ans: C;


Inflation could make NOI grow at the inflation rate over time. As long as inflation is passed through, it will not affect valuation because the market cap rate also incorporates the inflation rate.




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