ALTERNATIVEINVESTMENTSAnswersQuestion Part A Advantages: Earlier and steadier cash flows Less frequent losses Less error in the measurement of returns The potential for using higher leverage Disadvantage: less upside potential than venture capital Sample Scoring Key: point each for two advantages and one disadvantage Part B Comment "Private equity is more of a diversifier than a long-term return enhancer." "There is also the carried interest, which is interest limited partners have to pay to cover the financing costs of leverage." “You should use real estate investments in raw land rather than buyout funds to generate more immediate cash flow.” “I want to make sure that the preferred is structured so that later investors can receive seniority in order to increase their claim on the company assets.” Is the comment correct? (circle one) Yes No Yes No Yes No Yes No Explanation The high correlation to equity reduces any portfolio diversification benefit Carried interest is the share of the profits that is paid to the manager Raw land generally provides no cash flow Buyout funds may generate income in excess of financing costs and provide a more immediate cash flow to investors Subsequent rounds of convertible preferred are generally issued senior to the earlier rounds, reducing the early investors’ claim on company assets Sample Scoring Key: point each for correctly identifying whether the comment is correct point for each explanation points if yes/no decision is incorrect Question Part A Backfill bias—managers who build a successful track record then begin to report results and the past successful returns are then added to the index, biasing returns upward Survivorship bias—the past record of a fund that goes out of business is removed from the index These funds are more likely to have a poor record, biasing upward the reported return record Only the surviving funds are reported Sample Scoring Key: point each for explaining each term and points for explaining how and why it biases reported returns upward Part B i Illiquidity leads to a lack of trading and the use of appraisal data for prices Infrequent appraisal data leads to less volatile prices and distorts downward reported standard deviation used in the denominator of the Sharpe ratio, biasing the Sharpe ratio upward ii A manager can increase reported return by compounding sub period return used in the numerator of the Sharpe ratio while reducing the related reported standard deviation used in the denominator by using multiplicative annualization The combined result is to increase the Sharpe ratio Sample Scoring Key: points for each explanation For full credit, the explanation must describe numerator and/or denominator issues Question Part A Significant diversification: True All three classes have low correlation to traditional stock and bond portfolios, providing significant diversification Sufficient liquidity: False Real estate is not a regularly traded asset, and even if MWM does monthly valuation, the underlying assets lack liquidity True Commodity positions are generally taken with liquid derivative positions True Managed futures typically use exchange traded derivative positions, and those are liquid o (Alternative answer and explanation: False Managed futures can be a subset of hedge funds, and the manger may be using illiquid positions and strategies that cannot be unwound.) Sample Scoring Key: One point each for: each asset class with a correct explanation of most likely true or false There are three asset classes and two features to discuss, for six points in total Candidate discussion: Explain implies you will receive no credit for only saying true or false Low correlation and liquidity of the underlying assets are the driving factors to the explanations Managed futures reflect manager skill and are not considered an asset class with inherent characteristics We don’t know the strategies used, allowing true or false for liquidity if properly explained Part B Manager strategy: Slide indicates MWM is using commodities in a managed futures approach of selectively taking long positions in backwardation markets and short positions in contango markets to earn positive roll She is not just long commodities to gain asset class exposure Sample Scoring Key: One point for “manager strategy.” Three points for the explanation Candidate discussion: The key is that MWM targets value added in both downward (backwardation) and upward-sloping (contango) markets In other words, the manager takes long and short positions This is not long-only (commodity as an asset class) investing but a managed futures strategy applied to the commodity market Simply stating MWM takes both long and short positions earns one of the three explanation points That statement alone is weak (in a 4point question) when you had the information and training to elaborate You should convey to the grader how you know and support the decision Describing the manager strategy to earn positive roll return in both types of markets would be a convincing way to so You could mention the slide states they are active cash managers but should not expect any credit Simply being an active manager is not the issue The issue is that the slide indicates both long and short positions are used, so there can be no inherent asset class characteristics (In contrast, long-only positions in commodity futures provide the inherent asset class characteristics of commodities.) Part C Advantages: It represents investable securities It represents liquid investments It is not subject to appraisals and smoothing problems Disadvantages: It reflects blended characteristics of RE and equity It reflects leveraged and over-stated return results Sample Scoring Key: One point for each advantage listing two and one point for each disadvantage listing two The question is based on knowing how NAREIT and NCREIF indexes differ and match up with evaluating a manager who purchases RE properties ... whether the comment is correct point for each explanation points if yes/no decision is incorrect Question Part A Backfill bias—managers who build a successful track record then begin to report... explanation For full credit, the explanation must describe numerator and/or denominator issues Question Part A Significant diversification: True All three classes have low correlation to traditional... True Managed futures typically use exchange traded derivative positions, and those are liquid o (Alternative answer and explanation: False Managed futures can be a subset of hedge funds, and the