Introduction

This unit covers Hedge Funds and Asset-Backed Securities: two categories of alternative investments that go beyond traditional mutual funds and ETFs.

Exam Weight: Part of 73% (~18 questions est. for Packaged Products & Alternatives chapter)

What You'll Learn

In this unit, you'll cover:

• Hedge Funds and Fund of Funds: How hedge funds are structured, their exemptions from registration, key characteristics (lock-ups, "2 and 20" fees, limited transparency), fund-of-funds diversification, and tax treatment via Schedule K-1
• Asset-Backed Securities (ABS): The securitization process, general ABS characteristics, Collateralized Mortgage Obligation (CMO) tranche types (Planned Amortization Class, Targeted Amortization Class, companion, Z-tranche, interest-only/principal-only strips), prepayment and extension risk, and Collateralized Debt Obligation (CDO) waterfall structures
• Key Risks: How prepayment risk, extension risk, credit risk, liquidity risk, and transparency risk apply differently across hedge funds, CMOs, CDOs, and other ABS

Why This Matters

Hedge funds and asset-backed securities are among the most complex and frequently tested products on the Series 7 exam. Unlike registered investment companies, these products carry unique structural risks:

• Lock-up periods restrict redemptions
• Double-layer fees in fund-of-funds structures
• Tranche priority determines cash flow order
• Interest-only (IO) and principal-only (PO) strips behave inversely to rates

Understanding the underlying mechanics helps you answer questions about which tranche bears the most risk, how prepayments affect different investors, and why hedge fund investors face liquidity constraints that mutual fund investors do not.

Let's start with hedge funds and fund of funds.