IFC Alternative Managed Products 4 — Questions and Answers
Question 1: When conducting due diligence on a hedge fund, which operational risk factor is considered a critical 'red flag' according to industry best practices?
- Use of a well-known third-party prime broker
- Fund administrator and investment manager are the same entity (self-administration) (Correct answer)
- Monthly rather than daily NAV calculation
- Auditor is a mid-sized regional accounting firm
Correct answer: Fund administrator and investment manager are the same entity (self-administration)
Self-administration — where the manager also controls the calculation and custody of assets — removes a key independent check and significantly increases the risk of fraud or error.
Question 2: A high-net-worth client asks about investing in an exempt market hedge fund via an offering memorandum. Which suitability factor is MOST critical to assess before recommending it?
- The fund manager's years of experience in the industry
- The client's liquidity needs given the fund's lock-up and redemption restrictions (Correct answer)
- Whether the fund charges performance fees
- The fund's historical maximum drawdown over five years
Correct answer: The client's liquidity needs given the fund's lock-up and redemption restrictions
Liquidity suitability is paramount because many exempt-market hedge funds impose lock-up periods, gates, or quarterly redemption windows that can trap capital when clients need it.
Question 3: In the context of alternative managed products, 'gates' refer to:
- Regulatory barriers preventing retail investors from accessing hedge funds
- Provisions allowing the fund manager to limit or suspend redemptions during stressed market conditions (Correct answer)
- Performance hurdles that must be exceeded before a performance fee is earned
- Maximum position size limits imposed by the fund's investment policy statement
Correct answer: Provisions allowing the fund manager to limit or suspend redemptions during stressed market conditions
Gates are provisions that allow a fund manager to restrict or delay investor redemptions when redemption requests exceed a specified threshold, protecting remaining investors from forced asset sales.
Question 4: Which of the following alternative strategies is MOST appropriate for an investor whose primary goal is to profit from pricing inefficiencies between a company's convertible bonds and its common equity?
- Global macro strategy
- Long/short equity strategy
- Convertible arbitrage strategy (Correct answer)
- Managed futures (trend-following) strategy
Correct answer: Convertible arbitrage strategy
Convertible arbitrage exploits mispricing between a company's convertible bonds and underlying equity by simultaneously taking offsetting positions in both securities.
Question 5: A global macro hedge fund manager believes interest rates in Canada will rise sharply. Which position best reflects this directional view?
- Long Canadian government bond futures
- Short Canadian dollar relative to the US dollar
- Short Canadian government bond futures (Correct answer)
- Long Canadian equity index futures
Correct answer: Short Canadian government bond futures
Rising interest rates cause bond prices to fall, so a manager expecting higher rates would short bond futures to profit from the anticipated price decline.
Question 6: Which regulatory document must a prospective investor in an exempt-market alternative fund receive and acknowledge before investing?
- Simplified prospectus and Fund Facts document
- Offering memorandum (OM) and risk acknowledgement form (Correct answer)
- Annual information form only
- Mutual fund prospectus approved by a securities commission
Correct answer: Offering memorandum (OM) and risk acknowledgement form
Exempt-market products sold via the offering memorandum exemption require investors to receive the OM and sign a risk acknowledgement confirming they understand the speculative nature of the investment.
Question 7: Which of the following best illustrates the concept of 'absolute return' as it applies to alternative managed products?
- A fund benchmarked against the S&P/TSX Composite that outperforms by 3%
- A fund that aims to generate positive returns regardless of whether equity markets rise or fall (Correct answer)
- A fund with returns guaranteed by the issuing financial institution
- A fund that returns exactly the amount originally invested at maturity
Correct answer: A fund that aims to generate positive returns regardless of whether equity markets rise or fall
Absolute return strategies target positive performance in all market conditions rather than beating a benchmark, using tools like short selling and derivatives to reduce directional market exposure.
IFC Alternative Managed Products 4
When conducting due diligence on a hedge fund, which operational risk factor is considered a critical 'red flag' according to industry best practices?