Common Mistakes to Avoid
Watch out for these exam traps that candidates frequently miss on Alternative Investments questions:
Not understanding accredited investor requirements
Forgetting hedge fund lock-up periods
Confusing commodities futures with physical commodities
Sample Practice Questions
Which of the following individuals would qualify as an accredited investor based on income?
A is correct. An individual qualifies as an accredited investor with $200,000 annual income (or $300,000 joint income with spouse) for the past two years, with a reasonable expectation of maintaining that level in the current year. Both the historical track record and future expectation are required.
B ($150,000 annual income) is incorrect because this falls below the $200,000 threshold for individual income. C ($250,000 current year only) is incorrect because accredited investor status requires income for the past two years, not just the current year. D ($300,000 liquid net worth) is incorrect because the net worth test requires $1 million excluding primary residence, not $300,000 in liquid assets.
Accredited investor requirements appear frequently on the Series 65 because they determine access to private placements, hedge funds, and other alternative investments. The exam tests whether you understand both prongs of the income test: the two-year history requirement and the reasonable expectation for the current year. This distinction matters in client scenarios where someone just received a large bonus or promotion. Remember the thresholds: $200,000 individual or $300,000 joint income for TWO consecutive years.
A client is considering investing in a hedge fund with standard liquidity terms. Which of the following is the client MOST likely to encounter?
B is correct. Hedge funds typically impose lock-up periods of 1 to 2 years or longer during which investors cannot withdraw their money. This allows fund managers to implement longer-term strategies without worrying about sudden redemptions disrupting positions.
A (Daily redemptions at NAV) is incorrect because this describes mutual funds, not hedge funds. C (Immediate liquidity with T+1 settlement) is incorrect because hedge funds are highly illiquid investments, unlike exchange-traded securities. D (Weekly redemption windows) is incorrect because even after the lock-up period expires, hedge funds typically offer redemptions quarterly or annually with advance notice requirements, not weekly.
Lock-up periods are one of the most commonly tested features of hedge funds on the Series 65. The exam wants to ensure you understand that hedge funds sacrifice liquidity for potentially higher returns and unique strategies. Questions often present client scenarios where someone needs access to funds within a year, making hedge funds unsuitable. After the lock-up period, investors still face gate provisions (limits on redemption amounts) and notice periods (30 to 90 days advance warning). This illiquidity risk must be disclosed to clients.
A hedge fund charges a 2% annual management fee and a 20% performance fee on profits. If the fund has $100 million in assets and generates a 15% return for the year, what is the total fee paid to the fund manager?
D is correct. The traditional "2 and 20" fee structure works as follows: Management fee = 2% of $100M = $2M. The fund generated $15M in profits (15% of $100M), so the performance fee = 20% of $15M = $3M. Total fees = $2M + $3M = $5M.
A ($2 million) is incorrect because it only includes the management fee and omits the performance fee. B ($3 million) is incorrect because it only includes the performance fee and omits the management fee. C ($17 million) is incorrect because it mistakenly calculates 20% of the total assets plus the management fee, rather than 20% of profits.
Understanding hedge fund fee structures is essential for Series 65 questions about alternative investment costs. The "2 and 20" model (though declining to averages around 1.5% and 17% recently) significantly impacts net returns. The exam tests whether you can calculate both components and understand how high-water marks work to prevent double-charging after losses. These substantial fees must be clearly disclosed to clients, and advisers must assess whether potential returns justify the costs. Questions often ask you to compare hedge fund fees to traditional mutual fund expense ratios.
An investment adviser is explaining commodities investments to a client. Which statement about physical commodities versus commodities futures is correct?
A is correct. Physical commodities involve direct ownership of the actual goods (gold bars, oil barrels, etc.), requiring storage and insurance. Futures contracts are standardized agreements to buy or sell a commodity at a specified price on a future date, without requiring physical delivery unless held to expiration.
B (Both generate dividend income) is incorrect because commodities do not produce income. Unlike stocks or bonds, commodities generate no dividends or interest. C (Futures require immediate delivery) is incorrect because this reverses the reality. Futures settle at a future date, while buying physical commodities involves immediate ownership. D (Both highly liquid with daily trading) is incorrect because physical commodities are generally illiquid and difficult to sell quickly, whereas futures contracts trade on exchanges with high liquidity.
This distinction between physical commodities and futures contracts is frequently tested on the Series 65, as it's a common source of client confusion. The exam often presents scenarios where clients want commodity exposure but don't understand the differences. Physical ownership involves storage costs, insurance, and security concerns. Futures provide leveraged exposure without physical delivery but require understanding of margin requirements and rollover costs. Most retail investors access commodities through ETFs or ETNs rather than direct ownership or futures trading.
Which of the following best describes the liquidity characteristics of private equity investments?
C is correct. Private equity investments are characterized by very low liquidity, typically requiring investors to commit capital for 5 to 10 years or longer. These investments involve purchasing stakes in private companies that are not publicly traded, making exits difficult until a liquidity event occurs (sale, IPO, or merger).
A (Highly liquid with daily pricing) is incorrect because this describes mutual funds or ETFs, not private equity. Private equity lacks daily pricing and has no redemption mechanism. B (Moderately liquid with quarterly redemptions) is incorrect because even quarterly liquidity is unavailable in private equity. This might describe some interval funds, but not traditional private equity. D (Liquid through secondary exchanges) is incorrect because private equity interests rarely trade on secondary markets, and when they do, the markets are illiquid with limited buyers.
Private equity liquidity constraints are a critical suitability issue tested on the Series 65. The exam wants advisers to understand that clients investing in private equity must have sufficient liquid assets elsewhere and be able to forgo access to this capital for a decade. Questions often present scenarios where clients need funds for upcoming expenses, making private equity inappropriate. Minimum investments typically start at $250,000 or higher, and investors must be accredited or qualified purchasers. The illiquidity premium is the potential for higher returns that compensates for this lack of liquidity.
Master Investment Vehicles: 25% of Your Exam
Investment products make up the largest section of the Series 65. CertFuel targets the specific distinctions between bonds, stocks, funds, and alternatives that appear most often.
Access Free BetaA client invests in a Direct Participation Program (DPP) that generates a $15,000 loss in the first year. How can this loss be used for tax purposes?
D is correct. DPP losses are classified as passive losses under IRS rules and can only offset passive income from other passive activities such as other DPPs or rental real estate. This limitation prevents investors from sheltering ordinary income with passive losses from tax shelter investments.
A (Deduct against ordinary income without limitation) is incorrect because passive loss rules specifically prohibit this. The restriction was enacted to prevent abusive tax shelters. B (Deduct against capital gains from securities) is incorrect because capital gains are not passive income, so passive losses cannot offset them. C (Cannot be deducted and permanently lost) is incorrect because the losses can be used, just only against passive income. Unused passive losses can be carried forward to future years.
Understanding passive loss rules is essential for Series 65 questions about DPPs and tax planning. The exam frequently tests whether advisers know that DPP losses cannot shelter ordinary income. This knowledge is critical when evaluating DPP suitability, as clients expecting to use losses against their salary income will be disappointed. There is one notable exception: real estate investors who actively participate can deduct up to $25,000 of rental losses against ordinary income, phasing out between $100,000 and $150,000 AGI. Questions may present scenarios testing this distinction.
An investment adviser is explaining Exchange-Traded Notes (ETNs) to a client. Which risk is MOST specific to ETNs compared to Exchange-Traded Funds (ETFs)?
C is correct. ETNs are unsecured debt obligations of the issuing bank, exposing investors to the credit risk of that institution. If the issuer defaults or goes bankrupt, investors can lose their entire investment regardless of the underlying index performance. This was demonstrated when Lehman Brothers collapsed in 2008 and its ETN holders lost everything.
A (Market risk from underlying index) is incorrect because both ETFs and ETNs face market risk. This is not specific to ETNs. B (Liquidity risk from low trading volume) is incorrect because this can affect both ETFs and ETNs depending on the specific product. D (Tracking error) is incorrect because ETNs actually have an advantage here. Since the issuer promises exact index returns, ETNs typically have no tracking error, unlike ETFs which may diverge slightly from their index due to fees and management.
ETN credit risk is a high-priority exam topic because it's the key distinguishing feature from ETFs. The Series 65 tests whether advisers understand that ETNs have no underlying assets backing them, just the issuer's promise to pay. This makes issuer creditworthiness critical. Questions often contrast ETNs (unsecured debt with no tracking error but credit risk) with ETFs (own actual securities with slight tracking error but no credit risk). Clients may not understand this difference, making adviser explanation essential.
Which of the following individuals qualifies as an accredited investor based on net worth?
B is correct. The net worth test for accredited investor status requires $1 million or more in net worth, excluding the value of the person's primary residence. This individual meets the threshold.
A ($1.2 million including $500,000 primary residence) is incorrect because when you exclude the primary residence value, the net worth drops to $700,000, which falls below the $1 million requirement. C ($800,000 in investment accounts) is incorrect because this is below the $1 million threshold, even though the individual has no debt. D ($500,000 net worth with Series 65 license) is incorrect because while holding a Series 7, 65, or 82 license does create accredited investor status through the knowledge-based qualification, the net worth here is only $500,000, which alone is insufficient.
The net worth test for accredited investors is heavily tested on the Series 65 because the primary residence exclusion often confuses candidates. The exam frequently presents scenarios where clients appear wealthy but don't qualify once you exclude their home. This was changed after the 2008 financial crisis when home values dropped but people still accessed risky investments. Note the 2020 addition of the knowledge-based qualification: holding a Series 7, 65, or 82 license automatically makes someone an accredited investor regardless of income or net worth.
To maintain favorable tax treatment and avoid corporate-level taxation, a Real Estate Investment Trust (REIT) must distribute what percentage of its taxable income to shareholders?
D is correct. REITs must distribute at least 90% of their taxable income to shareholders to maintain their special tax status as a pass-through entity and avoid paying corporate income tax. This high distribution requirement makes REITs attractive for income-focused investors but limits the REIT's ability to retain earnings for growth.
A (50%) is incorrect because this is far below the actual requirement and would not qualify the REIT for pass-through taxation. B (70%) is incorrect. While 70% relates to REIT asset composition requirements (75% in real estate), it is not the distribution requirement. C (100%) is incorrect because REITs are not required to distribute all income, just 90% or more. Retaining up to 10% allows some flexibility for operations.
The 90% distribution requirement is one of the most frequently tested REIT characteristics on the Series 65. This rule explains why REITs typically offer high dividend yields compared to regular stocks, making them suitable for income-seeking clients. However, candidates must also know that REIT dividends are taxed as ordinary income, not at the preferential qualified dividend rate. Questions often test whether you understand the trade-offs: high current income but ordinary income tax rates and limited growth from retained earnings. The exam may present scenarios comparing REITs to growth stocks for different client objectives.
An investment adviser is asked about leveraged ETFs. Which of the following statements about these products is correct?
C is correct. Leveraged ETFs reset their leverage ratio daily, which causes their long-term performance to diverge significantly from the multiple of the underlying index return. Due to volatility decay and compounding effects, these products are designed for short-term tactical trading, typically one day, and are generally unsuitable for longer holding periods.
A (Suitable for long-term buy-and-hold) is incorrect because this is precisely what leveraged ETFs are NOT suitable for. The daily reset mechanism makes them inappropriate for long-term holding. B (2x ETF returns exactly double) is incorrect because the 2x multiplier only applies to daily returns. Over longer periods, compounding causes returns to diverge significantly from exactly double the index. In volatile markets, investors can lose money even if the underlying index ends flat. D (Eliminate market risk) is incorrect because leveraged ETFs actually amplify market risk. A 2x or 3x leveraged ETF will experience two or three times the volatility of the underlying index.
Leveraged ETF suitability is a critical exam topic because these products are frequently misunderstood by retail investors who see "2x returns" and assume they'll double their money. The Series 65 tests whether advisers understand the daily reset mechanism and volatility decay that makes these unsuitable for most clients. Questions often present scenarios where clients want to "buy and hold" a leveraged ETF, and the correct answer involves explaining the risks and suggesting alternatives. This is a suitability red flag that requires careful client education and documentation. FINRA has specifically focused on leveraged and inverse ETFs in regulatory guidance.
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