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Bionic Turtle FRM Practice Questions

P1.T3. Financial Markets and Products

Chapter 3. Fund Management

By David Harper, CFA FRM CIPM
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CHAPTER 3. FUND MANAGEMENT ........................................................................................ 3

P1.T3.705. MUTUAL FUNDS ..................................................................................................... 3
P1.T3.706 HEDGE FUNDS ........................................................................................................ 6

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Chapter 3. Fund Management

P1.T3.705. Mutual funds
P1.T3.706 Hedge funds

P1.T3.705. Mutual funds

Learning Objectives: Differentiate among open-end mutual funds, closed-end mutual
funds, and exchange-traded funds (ETFs). Calculate the net asset value (NAV) of an
open-end mutual fund. Explain the key differences between hedge funds and mutual
funds.

705.1 America's Best Fund (Class A) is an open-ended mutual fund with 1.20 million shares
outstanding. Currently, it is 10 am U.S. eastern standard time (EST) in the morning and the fund
owns the following:
 $9.30 million in large cap equities,
 $1.0 million in short-term U.S. Treasury bills; aka, the risk-free asset, and
 $500,000 in cash
Which of the following statements is TRUE?
a) The fund's net asset value (NAV) is about $7.75 per share
b) If the fund reinvests dividends earned on the equities, the fund's investors are not taxed
on these reinvested dividends
c) An immediate order to buy shares, at 10 am, can specify the total dollar amount but will
know neither the exact NAV nor exact number of shares purchased
d) Unless and until the fund issues additional shares in a secondary offering or initiates a
share buyback, the number of shares outstanding will remain fixed at 1.20 million

705.2. The Investment Committee at your endowment just analyzed the historical performance
of its asset allocation to hedge funds, which was 20.0% of the fund. It has determined that net of
fees these hedge funds did not outperform the S&P 500 on a risk-adjusted basis. Consequently,
the Committee wants to re-allocate this portion to a fund that tracks the S&P 500 index; and the
Committee is comfortable mirroring the index with minimum tracking error. An outside
consultant proposes an exchange-traded fund (ETF) such as the "Spider" (ticker SPY), but
some members want to compare the ETF to an open-ended or closed-ended mutual fund that
tracks the S&P 500.In addition to highlighting the fact that the expense ratios tend to be lower
for ETFs than mutual funds, the consultant offers the following arguments in favor of an ETF:
I. In contrast to an open-ended mutual fund, advantage of the SPDR ETF can be traded at
any time, can be shorted, and does not have to be partially liquidated to accommodate
redemptions
II. In contrast to a closed-ended mutual fund whose price tends to trade at a discount to its
fair market value, there is never any appreciable difference between the traded price of
the SPDR EFT and its fair market value.
Which of the consultant's argument(s) is (are) TRUE?
a) Neither is true
b) Only I. is true, but II. is false
c) Only II. is true, but I. is false
d) Both are true.

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705.3 Quadholding Mutual is a mutual fund in the United States who reports the following
sequence of per annum returns over the last five years: +7.0%, +15.0%, +20.0%, +5.0%,
+18.0%. Quadholding Mutual charges a back-end load of 2.0%. Each of the following
statements about this mutual fund is true EXCEPT which is false?
a) Quadholding's five-year geometric mean must be less than 13.0%
b) Unlike a hedge fund, Quadholding must disclose its investment policies, must limit it its
use of leverage, must calculate NAV daily, and must make its shares redeemable at any
time
c) When purchasing shares in Quadholding, a 2.0% fee will be charged to the investor; and
if the shares are held for five years then subsequently sold, then the total expense ratio
amortizes to about 40 basis points per year
d) Quadholding is heavily regulated primarily by the Securities and Exchange Commission
(SEC) who does not permit the illegal practice of "late trading;" although investors can
legally engage in "market timing" or "front running" the fund but only if such trades are
based on publicly available information

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Answers:

705.1. C. TRUE: An immediate order to buy shares, at 10 am, can specify the total dollar
amount but will know neither the exact NAV nor exact number of shares purchased.

In regard to (A), (B) and (D), each is FALSE. In regard to false (A), the fund's NAV is about
($9.30 + 0.50 + 1.0)/1.20 mm = $9.00 but it will fluctuate throughout the day.

705.2. D. Both [statements] are true.

Exchange-traded funds (ETFs) offer several advantages over open-ended and closed-ended
mutual funds:
 Because institutional investors exchange their ETF shares for the underlying assets,
unlike closed-end funds, there is never a material difference between the ETF share
price and its fair market value.
 ETFs can be bought or sold at any time of the day. ETFs can be shorted just like stock
can be shorted. ETF holdings are disclosed twice a day.
 ETF expense ratios tend to be lower than mutual fund expense ratios.

705.3. C. False. The front-end load fee is charged when the investor first buys the fund,
and the total expense ratio is the total annual fee which includes at least management
expenses and distribution costs.

In regard to (A), (B) and (D), each is TRUE.

 In regard to true (A), the geometric mean is 12.841%, which is less than the arithmetic
mean by about one-half the variance of the series
 In regard to true (B), hedge funds, because their investors are supposedly
sophisticated, are subject to less regulation than a mutual fund. Mutual funds must make
its shares redeemable at any time; must calculate their NAV daily; must disclose their
investment policies; and cannot use leverage without limit.
 In regard to true (D), see Hull's Regulation and Mutual fund Scandals1.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t3-705-mutual-funds-

hull.10282/

1
John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New Jersey: John
Wiley & Sons, 2018).

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P1.T3.706 Hedge funds

Learning Objectives: Calculate the return on a hedge fund investment and explain the
incentive fee structure of a hedge fund including the terms hurdle rate, high-water mark,
and clawback. Describe various hedge fund strategies, including long/short equity,
dedicated short, distressed securities, merger arbitrage, convertible arbitrage, fixed
income arbitrage, emerging markets, global macro, and managed futures, and identify
the risks faced by hedge funds. Describe hedge fund performance and explain the effect
of measurement biases on performance measurement.

706.1. A fund of funds divides its money equally between four hedge funds who earn –3.0%,
+1.0%, +11.0%, and +21.0% before fees in a particular year. The fund of funds charges "1%
plus 10%" and the hedge funds charge "1% plus 20%" (due to competitive pressures this is
reduced from "2% plus 20%"). The hedge funds' incentive fees are calculated on the return after
management fees. The fund of funds incentive fee is calculated on the net (after management
and incentive fees) average return of the hedge funds in which it invests and after its own
management fee has been subtracted. Which is nearest to the return to investors in the fund of
funds? (please note this is inspired by Hull's EOC Question 4.17)2
a) 1.40%
b) 3.60%
c) 5.00%
d) 7.50%

706.2. Hedge fund fees are notoriously high, although recently the traditional "2 and 20" fee
structure has been under much pressure. Clauses in fee structure agreements can help make
the incentive fees more palatable for clients. In regard to these fee structure agreement clauses,
each of the following is a true description EXCEPT which is inaccurate?
a) Hurdle rate is the minimum return necessary for an incentive fee to be applicable
b) High-water market requires previous losses to be recouped before an incentive fee is
applicable
c) Clawback refers to investors being able to use some (or all) previous incentive fees, held
in a recovery account, to offset current losses
d) Proportional adjustment clause allows the hedge fund manager, in the event of style
drift, to replace the fund's benchmark, ex post, in order to reduce the funds reported
tracking error

2
John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New Jersey: John
Wiley & Sons, 2018).

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706.3. In regard to various hedge fund strategies, each of the following statements is generally
true EXCEPT which statement is false?
a) Although prior to 2009, hedge fund returns lagged the S&P 500, since 2009 hedge funds
have outperformed the S&P 500
b) A Distressed Securities hedge fund investor is more likely to earn an illiquidity risk
premium than a typical Global Macro manager
c) A Merger Arbitrage (aka, risk arb) hedge fund investors should have a lower correlation
to the broad equity markets than a typical Long/Short Equity manager
d) A Systematic Managed Futures hedge fund investor is more likely to employ technical
analysis than an Emerging Markets manager

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Answers:

706.1. B. 3.60%. Please see the calculations below, in particular:

 Gross return = (-3.0% + 1.0% + 11.0% + 21.0%)/4 = 7.50%
 Total hedge fund fees = 1.0% management fee + 1.50% (average) performance fee =
2.50%
 Fund of fund fees = 1.0% management + 0.40% performance = 1.40%
 Return to investor = 7.50% - 2.50% - 1.40% = 3.60%

706.2. D. False. A proportional adjustment clause is related to a high-water mark.

In regard to (A), (B) and (C), each is TRUE.

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706.3. A. False. Prior to 2009, hedge fund returns generally beat the S&P 500, but since
2009 hedge funds have generally lagged behind the S&P 500

In regard to (B), (C) and (D), each is TRUE.

 In regard to true (B), Distressed Securities an event-driven strategy that typically
requires high level of skill making investments that lack liquidity; i.e., alpha and illiquidity
risk premiums. On the other hand, Global Macro tends to make directional bets in highly
efficient markets.
 In regard to true (C), Merger Arbitrage is an event-driven strategy but Long/Short
Equity is directional with market exposure; please note the difference between long/short
equity and equity market neutral.
 In regard to true (D), Managed Futures classically divided into discretionary versus
systematic (albeit with blurring lines recently) where the Systematic Managed Futures
strategy tends to be highly technical. Emerging Markets, on the other hand, tends to
require more fundamental analysis.

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