CFA Level I Alternative Investments Practice Questions
Question 1
An analyst finds that an appraisal-based private real estate index has far lower standard deviation and lower correlation with equities than a publicly traded REIT index over the same period. What is the best explanation?
- A. Appraisals lag transaction prices and smooth reported values, which understates true volatility and correlation
- B. Private real estate cash flows are contractually fixed, so the underlying asset values truly carry little risk
- C. Private properties are held across many countries, so most of their risk is diversified away
- D. Private real estate returns are measured over longer holding periods, which mathematically lowers annualized volatility
Show answer and explanation
Correct answer: A. Appraisals lag transaction prices and smooth reported values, which understates true volatility and correlation
Appraisal-based indexes rely on valuations that adjust slowly to market information, which smooths the return series. The result is understated standard deviation and correlation with other assets, so the index overstates the diversification benefit relative to the true economic risk.
- A. Correct. Appraisal smoothing is the known bias in appraisal-based real estate indexes.
- B. Lease cash flows are not riskless, and property values still change with market conditions.
- C. Geographic mix does not explain the index's artificially low volatility.
- D. Annualizing does not change true volatility; the low figure comes from smoothed valuations, not holding-period length.
Question 2
Hedge fund index returns are often criticized for overstating the true historical performance of the broad hedge fund universe. Which bias arises specifically because funds that closed down or stopped reporting are dropped from the historical index database, leaving only the (typically better-performing) funds that survived?
- A. Look-ahead bias
- B. Survivorship bias
- C. Backfill (instant history) bias
- D. Currency translation bias
Show answer and explanation
Correct answer: B. Survivorship bias
Survivorship bias occurs when historical index returns are calculated using only funds that are still operating and reporting today, systematically excluding funds that failed or stopped reporting (often due to poor performance), thereby overstating average historical returns. This is distinct from backfill bias (Choice C), where a new fund's historical track record is added retroactively to an index only after it decides to start reporting (self-selecting for funds with good early histories), and from look-ahead bias (Choice A), which involves using information not actually available at the time of a decision. Currency translation bias (Choice D) is not a standard hedge fund database bias.
- A. Look-ahead bias involves using information not actually available at the time of an analysis, such as data revisions, not the exclusion of failed funds from a historical database.
- B. Survivorship bias arises when funds that closed or stopped reporting drop out of the historical database, leaving only surviving, typically better-performing funds and overstating the index's historical returns.
- C. Backfill (instant history) bias occurs when a fund's past returns are added to the index only once it decides to start reporting, typically after a good track record, which is a related but distinct bias from failed funds being dropped.
- D. Currency translation bias concerns distortions from converting returns across currencies, unrelated to funds dropping out of a database after closing.
Question 3
The 'J-curve effect' commonly observed in private equity fund performance refers to the tendency for
- A. Net asset value to decline continuously throughout the entire life of the fund
- B. Returns to rise in a steady, linear pattern over the entire life of the fund
- C. Returns to be highest in the fund's first year because of upfront carried interest payments to the general partner
- D. Reported returns to be negative in the fund's early years, due to fees and unrealized investment costs, before turning positive as portfolio companies mature and are exited
Show answer and explanation
Correct answer: D. Reported returns to be negative in the fund's early years, due to fees and unrealized investment costs, before turning positive as portfolio companies mature and are exited
The J-curve effect describes the typical pattern in private equity fund returns: early negative or low reported IRRs stemming from management fees, deal costs, and the J-curve's characteristic lag before investments are marked up or exited, followed by improving and eventually positive returns as portfolio companies mature and are realized.
- A. Incorrect. A continuous decline throughout the fund's life contradicts the eventual recovery and positive returns the J-curve describes.
- B. Incorrect. A steady linear rise does not match the characteristic dip-then-rise 'J' shape the effect is named for.
- C. Incorrect. Carried interest is earned on profits upon successful exits, typically later in the fund's life, not as an upfront first-year payment.
- D. Correct. This is the standard description of the J-curve: early dip from fees/costs, later rise as value is created and realized.
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A hedge fund manager runs a "long/short equity" strategy. What is the primary objective of taking both long and short equity positions in this strategy?
- A. To reduce net exposure to broad market movements while profiting from relative mispricing between selected securities
- B. To guarantee a positive return regardless of market conditions
- C. To eliminate all risk in the portfolio through broad diversification
- D. To maximize leverage on a single directional market bet
Show answer and explanation
Correct answer: A. To reduce net exposure to broad market movements while profiting from relative mispricing between selected securities
Long/short equity managers buy stocks they expect to outperform and short-sell stocks they expect to underperform, which can reduce net market exposure (the portfolio's overall beta) while still capturing returns from the manager's stock-selection skill (relative value). It does not guarantee positive returns (Choice B) or eliminate risk entirely (Choice C), and it is not primarily about maximizing directional leverage (Choice D) — that would describe a purely directional strategy.
- A. Correct — the primary goal of long/short equity is to reduce or neutralize exposure to overall market direction while capturing returns from the manager's relative security selection, longs expected to outperform, shorts expected to underperform.
- B. Incorrect — long/short strategies don't guarantee positive returns in all conditions; they can still lose money if the manager's relative bets are wrong, even with reduced market exposure.
- C. Incorrect — long/short strategies don't eliminate all risk; they specifically retain, and aim to profit from, stock-specific and relative-value risk while reducing market risk.
- D. Incorrect — this describes the opposite of the strategy's purpose; long/short investing reduces directional market bets rather than maximizing leveraged exposure to one direction.