42 RELATE TO ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGE...

Questions 37-42 relate to Alternative Investments for Portfolio Management.

Cynthia Farmington, CFA, manages the Lewis family's $600 million securities portfolio.

Farmington and the Lewis family have agreed that they should hire a manager of alternative

investments to manage a portion of the portfolio containing those assets. As part of the hiring

process, they attempted to perform the necessary due diligence. They assessed each

manager's organization, the relative efficiency of the markets each manager has invested in,

the character of each manager, and the service providers, such as lawyers, that each manager

has used. In particular, they hoped to find a manager who has run an operation with low

employee turnover, has invested in efficient and transparent markets, has sound character,

and has utilized reputable providers of external services.

Eventually, Farmington hires the firm owned and managed by Bruce Carnegie, CFA, to

diversify the Lewis portfolio into alternative investments. Carnegie will manage the portion

of the portfolio containing these assets, and Farmington will continue to manage the

remainder of the portfolio in a mix of approximately 50/50 high-grade stocks and bonds.

Over the past ten years, the stock portion of the portfolio has closely tracked the S&P 500 and

the bond portfolio has closely tracked a broad bond index.

Carnegie and Farmington meet to discuss how Carnegie should proceed. Farmington

mentions that she and the Lewis family have agreed that the main goal of alternative

investments that Carnegie will manage in the $600 million securities portfolio should be to

enhance the return of the overall portfolio. Diversification is only a secondary goal. In

particular, Farmington says the Lewis family has expressed an interest in having the portfolio

take positions in private equity. Farmington says that she envisions that Carnegie should take

five positions of about $5 million each in distinct private equity investments, and each

position should have a short time horizon of about two years.

Farmington states that she has grown very dependent on benchmarks for her investing

activities, and she has concerns with respect to how she and Carnegie will monitor the

success of the portfolio allocation in private equity. She has read that there can be a problem

with the valuation of private equity indices in that they depend on price-revealing events like

IPOs, mergers, and new financing. Thus, the repricing of the index occurs infrequently.

Carnegie concludes that the solution is to follow the commonly accepted practice of creating

their own private equity benchmark.

Farmington asks Carnegie to explain the choices that exist in the private equity market.

Carnegie explains that there are two basic categories: venture capital funds and buyout funds.

Farmington asks that Carnegie explain the pros and cons of one over the other. Carnegie

states that although buyout funds would probably have lower return potential, they tend to

have fewer losses, earlier cash flows, and less error in the measurement of the returns.

Carnegie comments that before he proceeds he will need to communicate with the clients.

Farmington says this communication is not necessary because the Lewis family has largely

followed her advice with very few questions. Even when the market has fallen and the

portfolio has not done well, the Lewis family has not asked for any changes.

...

With respect to the criteria that Farmington used to choose a manager of alternative assets,

which of the following is not a due diligence checkpoint? Finding a manager who:

A) has low staff turnover.

B) invests only in efficient and transparent markets.

C) has stable providers of external services.

Question #38 of 60

Given that Farmington states that increased return is more important than diversification, the

choice to focus on private equity is:

A) not appropriate because private equity offers good diversification, but the returns are

comparatively low.

B) appropriate because private equity offers a high return but relatively low diversification.

C) appropriate because private equity offers both a high return and good diversification.

Question #39 of 60

Regarding Farmington's recommended private equity allocations and time horizon, which of

her guidelines is least appropriate?

A) The horizon is too short.

B) Too few positions for proper diversification.

C) Too much invested given the size of the overall portfolio.

Question #40 of 60

With respect to the issue of benchmarks, Farmington made an observation concerning the

potential problem with benchmarks, and Carnegie offered a solution. With respect to their

discussion, are Farmington and Carnegie correct or incorrect?

A) Only Farmington is correct.

B) Only Carnegie is correct.

C) Both are correct.

Question #41 of 60

Regarding Carnegie's statement comparing buyout funds to venture capital funds, the

statement is true:

A) even though venture capital funds tend to have lower average returns than buyout funds.

B) with regard to mega-cap buyout funds only, because middle-market buyout funds' returns tend

to be delayed.

C) with regard to middle-market buyout funds only, because mega-cap buyout funds' returns tend

to be more uncertain.

Question #42 of 60

With respect to the special issues that an alternative investment manager should address with

a private wealth client, from the conversation between Farmington and Carnegie, Carnegie

will need to discuss all of the following with the possible exception of:

A) tax issues.

B) other closely held investments.

C) decision risk.

Question #43 of 60