THROUGH 42 RELATE TO ALTERNATIVE INVESTMENTS. TANYA COHE...

Question

Questions 37 through 42 relate to Alternative Investments.  Tanya Cohen Case Scenario Tanya Cohen is the chief financial officer at ‘The York Investment Firm’ (YIF), an asset management firm established in New York, U.S.A. YIF is known in the investment community as a successful equity portfolio management firm and a reliable investment research provider. Due to high success with portfolio strategies in the equity market, Cohen has now expanded the firm’s services to include other asset classes including modern alternative investments like hedge funds, managed futures and distressed securities, as well as traditional alternative investments like commodities and real estate. One of the firm’s clients, who has been offered the opportunity to invest in alternative investments, is Dean Wilson, a successful entrepreneur owning and operating a business worth $35 million. Cohen has advised Wilson to invest in a private equity fund offered by the firm. Although the fund has the possibility of generating extreme returns relative to the mean, with some unusual degree of frequency, Cohen believes that Wilson has the ability to bear high risk given his accumulated wealth. During a client meeting with Wilson, Cohen convinced him to invest in the fund to capture return and diversification benefits. YIF introduced an investment vehicle around two years ago that tracked the commodity sector of the U.S. market. The benchmark for the fund is the S&P Commodity Index, an index that provides returns comparable to passive long positions in commodity futures contracts. Cohen is trying to determine the return to this index for the current year. He noticed that relative to the previous year, the U.S. economy most likely entered the early expansion phase this year since interest rates decreased and investor confidence rose. In addition, inventory levels for commodity producing companies remained low, but started to rise as producers began to stock inventories in anticipation of future growth. Cohen is trying to estimate the effects of these changes on the commodity index return components.  The York Investment Firm also offers its clients hedge funds following equity based strategies, including equity market neutral, hedged equity and merger arbitrage strategies. William Hiney and Gregor Tavenner are portfolio managers at the firm heading the team responsible for the management of the hedge funds. YIF pays a 2% AUM fee to hedge fund managers and a 20% incentive fee subject to a high water mark provision. In 2007, Exhibit 1 Highest net asset value achieved by hedge fund managers Year  Net Asset Value 2008  $62 million 2009  $60 million 2010  $62.5 million During a meeting with Cohen, Tavenner mentioned that the performance of the equity hedge funds at YIF was remarkable for the past few years. He stated that the hedge funds risk adjusted performance, as measured using the Sharpe ratio, was very high. For this reason, Tavenner proposed that YIF should advise high net worth clients and institutions with a high ability to bear risk, to invest more of their funds in these investment vehicles.  Cohen, however, is skeptical about the performance of the hedge funds. To corroborate Tavenner’s findings, Cohen gathers the following information: 1.   Almost all the equity hedge funds invest in a total return swap in which they pay the best and worst returns of their benchmark index each year and receive a fixed cash flow. 2.   The funds invest in illiquid assets that are marked to market infrequently. 3.   The managers used to calculate the Sharpe ratio using annualized standard deviation of monthly returns. Now they use the annualized standard deviation of daily returns. After his analysis of the firm’s hedge funds, Cohen reviewed an article on alternative investments to gain further insight into their historical performance and special issues and concerns. The article made the following comments: Statement 1:  “Due to certain limitations of the Sharpe ratio as a performance measurement tool for hedge funds, hedge fund managers use other ratios as part of their analysis. Two of these are the Calmar ratio and the Sterling ratio, both of which use a risk measure computed the same way, but use a different return measure in the numerator.” Statement 2:  “Hedge fund indices may not reflect true performance. One of the reasons is the lack of security trading which may lead to a stale price bias, lower correlations than expected, and lower measured standard deviations than would exist if actual prices existed.” Cohen is managing an endowment fund worth $45 million that supports social activities in the state of New York. The endowment’s required spending rate is 5.0% a year and since it has been established to serve social causes in perpetuity, the endowment’s board has an objective of preserving the real purchasing power of the assets. The fund is currently invested 60% in stocks and 40% in bonds, and the cost of earning investment returns is 75 basis points a year. Cohen is considering the inclusion of real estate as an asset class to improve the performance of the portfolio. Exhibit 2 presents the expected return and standard deviation of asset allocations excluding and including real estate. Exhibit 2 Forecast Data Measure  60/40 stocks/bonds (%)  50/35/15 stocks/bonds/direct real estate investment (%) Expected return  8.5%  8.2% Standard deviation  11.99%  10.01% The U.S. risk free rate is 3.5%, and the forecasted inflation rate is 2.5%. 37.  Given the above information, emphasis on which of the following factors related to alternative investment selection for Wilson should most likely be increased? A.   Decision risk and tax issues only. B.   Tax issues and determination of suitability only. C.   Decision risk, tax issues and determination of suitability. 38.  Given the information about the U.S. economy, what is the most likely impact of changes in the economy on the collateral return and roll return of the S&P Commodity Index? A.   The collateral return increased but the roll return decreased. B.   The roll return increased but the collateral return decreased. C.   Both the roll return and the collateral return decreased. 39.  Using the information given in Exhibit 1, hedge fund managers at YIF most likely earned incentive fees during the year(s): A.   2008 only. B.   2008 and 2010 only. 40.  Which of the above points that Cohen has gathered to assess the accuracy of the hedge funds performance at his firm would least likely inflate the stated Sharpe ratio? A.   1 only. B.   1 and 3 only. C.   3 only. 41.  The article on alternative investments is most accurate with respect to: A.   Statement 1 only. B.   Statement 2 only. C.   neither Statement 1 nor Statement 2. 42.  Should Cohen advise the endowment’s board to add real estate to their current portfolio? A.   No. B.   Yes, because adding real estate will improve the Sharpe ratio of the fund from 0.417 to 0.469. C.   Yes, because adding real estate will decrease the standard deviation from 11.99% to 10.01%.