TO 36 RELATE TO ALTERNATIVE INVESTMENTS AA WEALTH MANAGEM...

Questions 31 to 36 relate to Alternative Investments

AA Wealth Management Case Scenario

AA Wealth Management oversees the accounts of private wealth clients. Lester Doyle,

CFA, is AA’s alternatives investment specialist and has recently joined the firm after

serving ten years at a leading investment bank.

Doyle has been tasked with revising the portfolios of AA’s high net-worth clients which

are traditionally invested in fixed income and equity securities. Doyle is expanding client

portfolios and is particularly interested in the inclusion of fund of funds (FOFs)

investment offered by Celta. He assigns his subordinate, Lisa Mathews, to prepare a

presentation discussing the four strategies offered by the fund.

Hedge Fund Strategies Comprising Ceta’s FOF

Hedged Equity:

• Are market-neutral

• Suitable for investors desiring long equity exposures

• Take long and short positions in equity stocks belonging to the

same industry

Equity Market-Neutral:

• Have an overall beta of zero

• Earn alpha by exploiting mispricing of equity stocks

• Regarded as less of a return enhancing strategy

Short Selling:

Take short positions in emerging market securities as the

probability of market decline and thus profit potential is highest

Fixed-income Arbitrage:

Rita Singh is one of AA’s clients. Her investment portfolio is allocated to equities and

bonds in the proportion 30/70. Doyle is exploring the potential for allocating a further $3

million to the FOFs offered by Ceta. Prior to the allocation, Doyle arranges a meeting

with Singh where he makes the following observations:

Observation 1: She relies heavily on her investment portfolio to fund her son’s college

education and medical expenses. Her annual income is just sufficient to

support her living expenses.

Observation 2: She would like to be able to access performance track records with respect

to existing and non-existing fund holdings at all times.

Observation 3: She is looking for a low cost solution.

Doyle decides to pursue the FOF investment. He collects monthly return on the hedge

fund and its benchmark, the Hedge Fund Composite Index, for the previous year, 2014

(Exhibit 1). He will use the data to forecast future fund performance. Doyle’s investment

in the fund will be for a period of eight months. Doyle computes the roll returns on

Singh’s investment for that period.

Next Doyle evaluates whether the investment will improve the portfolio’s annualized

risk-adjusted performance. He compiles expected performance on the portfolio and the

hedge fund for the current year, 2015, in an exhibit (Exhibit 2).

Exhibit 1:

Monthly Returns For

Ceta’s Fund of Funds (2014)

Month Hedge Fund

January 15.7%

February 18.8%

March - 5.7%

April 12.7%

May 2.7%

June 9.8%

July 15.0%

August - 14.0%

September - 2.0%

Exhibit 2:

Current Performance of Singh’s Portfolio

And Hedge Fund Investment (2015)

Existing

FOFs

Portfolio*

Investment

Annualized Return (%) 9.7 14.8

Annualized risk-free rate

2.2

(%)

Annualized standard

15.0 28.9

deviation (%)

Correlation between

- 0.5

portfolio’s return and hedge

fund investment return

*Performance before the inclusion of the FOFs investment.

31. Is Mathews accurate with respect to her description of the:

equity market-

hedged equity

neutral strategy? short selling

strategy?

A. No No Yes

B. Yes No Yes

C. No Yes No

32. Mathews’ description of the fixed-income arbitrage fund strategy is inaccurate

because:

A. yield curve shifts are not incorporated.

B. only undervalued securities are sought.

C. portfolios are generally neutralized against directional market movements.

33. Based on Doyle’s meeting with Singh, a FOFs investment is least favorable based

on Observation:

34. Using the data in Exhibit 1, the value of Singh’s investment at the end of her

investment horizon using the eight month average rolling return is closest to:

A. $3.1709 million.

B. $3.1867 million.

C. $3.2063 million.

35. Using Exhibit 2, should Doyle allocate $3 million to the FOF?

A. No.

B. Yes, her portfolio’s risk-adjusted performance will improve.

C. Yes, her portfolio’s risk-adjusted performance will deteriorate.

36. A limitation of Doyle using the data in Exhibits 1 and 2 to analyze and forecast

risk-adjusted performance is:

A. future performance is difficult to predict.

B. consistency analysis is less relevant given fund composition.

C. hedge funds allow entry/exit into funds on a quarterly or less frequent

basis and so monthly returns are inappropriate.