36 RELATE TO ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGE...

Questions 31-36 relate to Alternative Investments for Portfolio Management.

William Bliss, CFA, runs a hedge fund that uses both managed futures strategies and

positions in physical commodities. He is reviewing his operations and strategies to increase

the return of the fund. Bliss has just hired Joseph Cantori, CFA, to help him manage the fund

because he realizes that he needs to increase his trading activity in futures and to engage in

futures strategies other than passively managed positions. Cantori is a registered commodity

trading advisor (CTA) who generally uses a contrarian strategy to manage futures. Bliss also

hired Cantori because of Cantori's experience with swaps, which Bliss hopes to add to his

choice of investment tools.

Bliss explains to Cantori that his clients pay 2% on assets under management and a 20%

incentive fee. The incentive fee is based on profits after having subtracted the risk-free rate,

which is the fund's basic hurdle rate, and there is a high water mark provision. Bliss is hoping

that Cantori can help his business because his firm did not earn an incentive fee this past year.

This was the case despite the fact that, after two years of losses, the value of the fund

increased 14% during the previous year. That increase occurred without any new capital

contributed from clients. Bliss is optimistic about the near future because the term structure

of futures prices is particularly favorable for earning higher returns from long futures

positions.

Cantori says he has seen research that indicates inflation may increase in the next few years.

He states this should increase the opportunity to earn a higher return in commodities and

suggests taking a large, margined position in a broad commodity index. This would offer an

enhanced return that would attract investors holding only stocks and bonds. Bliss mentions

that not all commodity prices are positively correlated with inflation, so it may be better to

choose particular types of commodities in which to invest. Furthermore, Bliss adds that

commodities traditionally have not outperformed stocks and bonds either on a risk-adjusted

or absolute basis. Cantori says he will research companies who do business in commodities

because buying the stock of those companies to gain commodity exposure is an efficient and

effective method for gaining indirect exposure to commodities.

Bliss and Cantori next discuss some of the issues that may affect client decisions to invest in

Bliss's fund. Cantori states that if they begin marketing to sophisticated institutional

portfolios, they can expect increased due diligence questions. They may be questioned on the

portfolio's risk management procedures.

Bliss states they must tighten up their risk budgeting process and impose tighter limits on

the amount of futures trades they do with each dealer while implementing payment

netting across all futures positions.

Cantori states that this will be even more important in commodity swaps where the fund

receives a commodity return and pays LIBOR because maximum potential credit risk

exposure typically continues up to swap expiration.

Bliss points out that sophisticated investors in the hedge fund will be more focused on risk

adjusted performance ratios such as Sharpe, Sortino, and Treynor.

...

Given the information, the most likely reason that Bliss's firm did not earn an incentive fee in

the past year was because:

A) of a high water mark provision.

B) the return did not exceed the risk-free rate.

C) the 2% asset-under-management fee is greater than the risk-free rate.

The only possible answer from the given reasons is a high water mark provision. Since the

firm had experienced losses for two years before increasing in value in the previous year, it is

likely that the value of the fund had yet to achieve a previous "high water mark" that it must

exceed in order for there to be an earned incentive fee.

For Further Reference:

Study Session 13, LOS 26.p

SchweserNotes: Book 4, p.77

CFA Program Curriculum: Vol.5 p.58

Question #32 of 60

Assuming Cantori continues to follow a contrarian futures trading strategy, his strategy

can best be described as a:

A) market trading strategy.

B) discretionary trading strategy.

C) systematic trading strategy.

CTAs that specialize in systematic trading strategies typically apply sets of rules to trade

according to or contrary to short, intermediate, and/or long-term trends. A discretionary CTA

trading strategy generates returns on the managers' trading expertise, much like any active

portfolio manager. CTAs can also be classified according to whether they trade in financial

markets, currency markets, or diversified markets.

Study Session 13, LOS 26.s

SchweserNotes: Book 4, p.80

CFA Program Curriculum: Vol.5 p.85

Question #33 of 60

Bliss is optimistic about the near future because the term structure of futures prices is

particularly favorable for earning higher returns from long positions. This would be the case

if the term structure is:

A) in contango.

B) relatively flat.

C) in backwardation.

Similar to a term structure of interest rates, the term structure of futures prices shows the

relationship at a point in time between futures prices and time to maturity. When the term

structure is negative (called backwardation), longer-term contracts have lower prices than

shorter-term contracts, so the curve is downward sloping. With the passage of time, the

maturity of a long-term contract shortens and its price rises to that of a shorter-term contract.

Thus, an investor can go long a long-term contract and profit as time passes, and the steeper

the curve (the greater the backwardation), the greater the potential returns. An upward-

sloping term structure of futures prices is called contango.

Study Session 13, LOS 26.n

SchweserNotes: Book 4, p.75

CFA Program Curriculum: Vol.5 p.53

Question #34 of 60

The points made by Cantori and Bliss during their discussion of commodity returns given

high inflation expectations were correct with the exception of:

A) Cantori's assertions concerning the indirect method of investing in stocks to gain commodity

exposure.

B) Bliss's assertion that not all commodities are positively correlated with inflation.

C) Cantori's assertion that a broad index would benefit from inflation.

Cantori says he will research companies who do business in commodities. He feels that using

the indirect method of buying the stock of those companies to gain commodity exposure is an

efficient and effective method for gaining exposure to commodities. This is not necessarily

true because those companies often hedge their exposure to commodities. The other

statements are true. Agricultural commodities tend to be negatively correlated with inflation,

but the broad commodity indices have been positively correlated with inflation. Also,

commodities have not generally outperformed stocks and bonds. They are attractive in that

they can provide a comparable return while diversifying the portfolio.

Question #35 of 60

Regarding the statements made by Bliss and Cantori on risk budgeting:

A) both are correct.

B) only Cantori is correct.

C) both are wrong.

Both are wrong in the details of what they said. Bliss would be correct for OTC instruments

such as forwards and swaps which have counterparty risk. But with exchange-traded futures,

there is no dealer counterparty risk and the procedures do not apply. Cantori would be correct

for currency swaps where notional principal is exchanged. For other types of swaps, the

maximum potential credit risk is typically midlife of the swap when there has been time for

market conditions to shift and large amounts continue to be at risk of exchange. The currency

swap is unique because the large notional exchange remains until the last day of the swap

life.

Study Session 14, LOS 27.i, j, k

SchweserNotes: Book 4, p.110, 115, 116

CFA Program Curriculum: Vol.5 p.173, 182, 186

Question #36 of 60

Regarding Bliss's comments on return ratios, the ratio least appropriate to the hedge fund is

likely to be the:

A) Sharpe.

B) Sortino.

C) Treynor.

Treynor is least appropriate because it is based on stock beta which is not going to apply to

the commodity markets. Downside risk measures like Sortino and would be the most

appropriate. The Sharpe ratio is based on standard deviation which assumes a symmetrical

distribution of returns. While it is often used in hedge fund evaluation, there are issues with

that application. Treynor is still the least appropriate.

Study Session 14, LOS 27.l

SchweserNotes: Book 4, p.118

CFA Program Curriculum: Vol.5 p.189

Question #37 of 60