Cfa Level Iii - Study Session 13

Front 1

Alternative Investments-
Definition

(SS13)

Back 1

1. Relative illiquity (a negative)
2. Diversifying potential (a positive)
3. High due diligence costs from lack of expertise and lack of transparency (a negative)
4. Hard to assess performance appraisal because it is difficult to choose an appropriate benchmark (a negative)
5. Alternatives are informationally less efficient which means there is more of an opportunity to profit from it (a positive)

Alternatives Assets:
i. Real estate
ii. Private equity
iii. Commodities
iv. Hedge funds
v. Managed futures
vi. Distressed securities

Front 2

Alternative Investments-
Who wants alternative assets?

(SS13)

Back 2

1. High net worth individuals
2. Institutional investors (although banks and insurers mayhave regulatory restrictions preventing them from buying in)
3. Endowments and some DB pension plans are good candidates for alternative assets because they have a big asset base and can afford to earn some illiquidity premiums.

NOT good for investors with short time horizons
NOT good for people with liquidity issues
NOT good if you're small because you have issues doing all the due diligence.

Front 3

Alternative Investments-
How do you assess an alternative asset manager?
(SS13)

Back 3

1. Market opportunity (why is it there and will it stay there)
2. Investment process (which manager exploits the inefficiencies the best?)
3. Organisation (is the firm well organised and stable)
4. People (do you trust them)
5. Terms and Structure (are the terms fair? are both of your interests aligned?
6. Service Providers (their lawyers, accountants etc
7. Documents (if you don't understand everything in them, get someone who does)
8. Write up (formal manager recommendation)

Front 4

Alternative Investments-
Core vs Satellite investing

(SS13)

Back 4

Everything that is competitively priced like large caps and gov bonds is put in the centre - core.
1. Because an alpha is hard to obtain with such assets, the CORE is managed in a PASSIVE risk-controlled way.
2. The satellite ring goes to investments that are designed to add alpha. Most alternative assets fit in here.

Front 5

Alternative Investments-
Real Estate
Direct

(SS13)

Back 5

Direct -
i. Residences
ii. Business (commercial) real estate
iii. Agricultural land

Front 6

Alternative Investments-
Real Estate
Indirect

(SS13)

Back 6

Indirect
i. Real estate developers, management - like homebuilders
ii. REITs
iii. CREFs - commingled or 'pooled' investment in real estate (i.e. open-end funds and closed-end funds)
iv. Separately managed accounts
v. Infrastructure funds (like citylink)

Front 7

Alternative Investments-
Real Estate
Benchmarks

(SS13)

Back 7

Direct
NCREIFs is essentially unlevered, so lower deviation than NAREIT
1. NCREIF Index
2. NCREIF Unsmoothed - (Appraisal based real estate has stale pricing, so unsmoothing corrects for the volatility dampening of the appraised values)

Indirect
REITs have higher deviation than NAREITs because they are leveraged so much
1. NAREIT
2. NAREIT Hedged (purged of its overall equity market return component, only for equity REITs because they are traded and therefore have a market risk)

Front 8

Alternative Investments-
Real Estate
Advantages

(SS13)

Back 8

1. Taxable owners may benefit from tax subsidies
2. Mortgages allow you to use more leverage than is available in most other investing
3. Direct control means you can fix the place up and take an active management to increase the market value
4. If you have houses all over the place, then you can achieve risk diversification benefits.
5. Low return volatility

Front 9

Alternative Investments-
Real Estate
Disadvantages

(SS13)

Back 9

1. Not divisable
2. Information is costly to get
3. High transaction fees
4. Big operating costs (like rates, bills etc)
5. Neighbourhood may deteriorate, which is out of your control
6. Income tax deductions may be discontinued at any point

Front 10

Alternative Investments-
Real Estate
Diversification Benefits

(SS13)

Back 10

1. Direct real estate may provide some diversification benefits when you just have stocks and bonds

BUT
direct real estate benefits aren't as useful if you are already diversified with other alternative assets like hedge funds and commodities

2. Real estate diversified with itself
Office space moves with the business cycle
Apartments are a more defensive play
3. Direct real estate also provides an inflation hedge

Front 11

Alternative Investments-
Real Estate
Example - Annette

(SS13)

Back 11

Solution 1.
i. Sharpe ratio of the 45/45/10 stock/bonds/US direct real estate investment portfolio (5.9%-3.5%)/10.8 = 0.222 is greater than that of the current 50/50 stocks/bonds allocation at (5.5%-3.5%/11.8 = 0.169
ii. Direct real estate has inflation-hedging qualities
iii. Real estate (in this eg) has increased return closer to meeting the investment objective
Solution 2. Proposed strategic asset allocation falls short of the (1.05)(1.03)(1.0020) -1 = 8.37 % return objective
inflation = 3%
cost of earning inv. returns = .2%
spending rate = 5%
Solution 3. Smoothing understates the volatility and correlations with other assets and therefore OVERstates the benefits of real estate in the portfolio. Use unsmooted for a better picture of what is going on.
Solution 4. Securitized real estate (ie indirect) is more liquid than direct real estate, but direct has better diversification benefits.

Front 12

Alternative Investments-
Private Equity
Funding stages

(SS13)

Back 12

1. Seed - small amount of money to form a company and prove that an idea has a reasonable chance of commercial success
2. Start-up - company is formed and idea has been proven but the co. needs money to bring product to market
3. First stage - After the seed and startup money has gone
4. Later stage
5. Pre-IPO or Mezzanine funding

Front 13

Alternative Investments-
Private Equity
The exit

(SS13)

Back 13

1. Merger with another company
2. Acquisition by another company (including a private equity fund)
3. an IPO to publicly traded market

Front 14

Alternative Investments-
Type of Private Equity Investment

(SS13)

Back 14

i. Direct venture capital investment is structured as convertible preferred stock NOT common stock. This stops the risk that the venture capital money will go in and just be distributed to the owners/ founders.
2. Expected life of private equity funds is about 7-10 years with an option for another 1-5
3. The 'carried interest' is the fund manager's incentive fee that is due to him/her after fund has returned money to the outside investors capital. Sometimes a hurdle rate comes in like 6% profit before they can get 20% profit.

Front 15

Alternative Investments-
Private Equity Benchmarks

(SS13)

Back 15

Value off
1. Recent market transactions (IPOs, new financing)
2. IRR based on cash flows, multiples
3. Private transaction with illiquidity premium

If there are no transactions or value of private equity it is really difficult to make a benchmark index.
People tend to use custom benchmarks in this space.

Seemingly good diversification benefits, but that may just be due to no pricing data available.
NOT ok to compare venture capital funds with different vintage years.

Front 16

Alternative Investments-
Private Equity Characteristics

(SS13)

Back 16

i. Illiquidity (preferred stock doesn't trade on a secondary market)
ii. Long-term commitments required (long and uncertain)
iii. Higher risk - than buying publicly traded companies. High failure rates
iv. High IRR to compensate for the risk and illiquidity
v. Limited information. A lot of assumptions are made, but the risk of small info also leads to the potential for unusual profits.

OK discounts for non-controlling minority interest
OK discounts for nonmarketable interest.

Front 17

Alternative Investments-
VC fund and buyout funds

(SS13)

Back 17

1. Buyout funds use debt (25-40%)
2. Buyouts see returns come back earlier than VC funds because buyouts buy established companies.
3. Returns to VC funds have greater errors in measurement. The VC fund manager estimates the returns in the fund.

Front 18

Alternative Investments-
Venture capitals role in the portfolio

(SS13)

Back 18

1. Private equity can play a moderate role as a risk diversifier.
2. Average VC allocation in a portfolio about 5%. You have to have enough money to be able to allocate $5m per VC times 5 to diversify makes min $25m investment in VC alone. Institutions are the best people for this type of investment.
Small guys need VC funds.
3. Liquidity of position
4. Provision for capital commitment (commitment period of generally 5 years)
5. Appropriate diversification strategy (early stage, expansion, buyout)

Front 19

Alternative Investments -
Commodities

(SS13)

Back 19

1. Commodities can be direct and indirect
Direct is cash purchase of physical with storage costs - agricultural products, metals and oil
Indirect is buying commodity companies
2. CTAs are commodity trading advisors. Only investments in commodities via cash and derivatives are considered alternative investing.
3. Commodity equity prices don't change closely enough with the prices of the commodities themselves.

NOT commodity companies
NOT managed funds of commodity companies

Front 20

Alternative Investments -
Commodity benchmarks

(SS13)

Back 20

1. Commodity indicies differ in the emphasis placed on various commodities and how to weight them.
2. As judged by Sharpe ratio it looks like commodities underperform, but they have correlations with S&P of close to zero which makes them good diversifiers
3. Commodities are not a homogeneous market of similar investments. The returns between them are also low, suggesting that they are not alike.

Front 21

Alternative Investments -
Commodity Index return components

(SS13)

Back 21

1. Return on a futures
does NOT equal return on spot.
2. Spot return
= change in futures - change in spot
3. Total return
= roll + collateral + spot
4. Physical commodities have 'positive event risk'. This can show as a positive change in spot price.
5. Collateral return comes from investing the futures contract value to earn risk free rate (also known as implied yield)
6. Roll return - rolling futures forward through time.
Backwardation = futures go down

Front 22

Alternative Investments -
Commodities characteristics

(SS13)

Back 22

Special risk characteristics of commodities
i. In economic distress, commodity prices tend to rise providing diversification benefits
ii. commodities are more impacted by short term expectations (stocks and bonds by long term expectations)
iii. Commodities are positively correlated with inflation (stocks and bonds are negative)
iv. A commodity return includes a convenience yield for holding the commodity. Low inventory levels have a high convenience yield
v. Real options
Where the oil refinery can decide whether or not to produce depending on the spot price. Production may only occur if futures are below current spot price.

Overall you want commodities in your portfolio because they
1. Provide natural sources of return based on fundamentals in the long term and provide protection against unexpected inflation.

Front 23

Alternative Investments -
Hedge Funds Types

(SS13)

Back 23

1. Equity Market Neutral - relative value
2. Convertible arbitrage - relative value
3. Fixed-income arbitrage
4. Distressed securities - event driven
5. Merger arbitrage - event driven
6. Hedged equity - relative value
7. Global Macro
8. Emerging Markets
9. Fund of Fund (FOF)

Front 24

Alternative Investments -
Hedge Funds Types
Equity Market Neutral

(SS13)

Back 24

Equity Market Neutral
i. A relative value strategy
ii. Tries to find over and undervalued equity securites while keeping beta = 0
iii. Has a low correlation with market returns
iv. Holds long and short positions that combine to make an equal exposure to the market
v. they can find returns because they aren't restricted from taking short positions, they can find inefficiencies
vi. Since they are absolute return strategies, their perfomance should not be linked to that of the stock market.
vii. These types of funds should be assess against a HURDLE rate, not a market index.

Front 25

Alternative Investments -
Hedge Funds Types
Convertible Arbitrage

(SS13)

Back 25

Convertible arbitrage
i. Look for price anomalies in convertible securities like convertible bonds, warrants and preferred stock.
ii. e.g. buy convertible bond and hedge the equity component
iii. they like volatility of the underlying asset and/or if the price of the asset goes up rapdly
iv. They may also like it when the credit quality of the issuer improves.

Front 26

Alternative Investments -
Hedge Funds Types
Fixed-income arbitrage

(SS13)

Back 26

Fixed income arbitrage
i. Managers try to find over and undervalued fixed income securities
ii. They think that term structures of ir's are going to change, or credit quality of issuers.
iii. They are neutralised agains market direction because the pf has long and short positions.

Front 27

Alternative Investments -
Hedge Funds Types
Distressed securities

(SS13)

Back 27

Distressed securities
i. They buy the debt and equity of companies that are in or near bankruptcy.
ii. A lot of legal hurdles, some institutional funds are even prevented from holding them.
iii. Most are LONG funds, because there is no real liquidity in the market to short them.

Front 28

Alternative Investments -Hedge Funds Types
Merger Arbitrage

(SS13)

Back 28

Merger Arbitrage
i. "Deal arbitrage"
ii. Buy equity of target after announcement and short the acquirers stock

Front 29

Alternative Investments -
Hedge Fund Types
Hedged equity

(SS13)

Back 29

Hedged equity
i. can have a net long position
ii. Hedged equity has the most AUM of the market.
iii. try to find over and undervalued securities

Front 30

Alternative Investments -
Hedge Fund Types
Global Macro

(SS13)

Back 30

Global Macro
i. Look for major moves in financial and non-financial markets
ii. trade currencies, futures, options and MAY also trade equities and bonds
iii. they look for major MARKET trends, not individual commodities

Front 31

Alternative Investments -
Hedge Fund Types
Fund of Funds (FOF)

(SS13)

Back 31

Funds of funds
i. Two layers of fees, one to the manager of the fund and another to the underlying hedge fund manager
ii. Smaller investors can buy into these and they provide more liquidity. To provide this they may have a cash buffer which may reduce expected returns.
iii. Advantages are the diversification benefits.
iv. Buys 10-30 hedge funds
v. Generally has no 'lock-up' period.

Front 32

Alternative Investments -
Hedge Fund Strategies

(SS13)

Back 32

1. Relative value
2. Event driven
3. Equity hedge
4. Global asset allocators
5. Short selling

Front 33

Alternative Investments -
Biases in index creation for hedge funds

(SS13)

Back 33

1. Hedge funds self report, so if they do poorly they are hardly going to tell anyone about it.
2. Low correlations between hedge funds, maybe coming from the size and age restrictions (i.e. nothing shorter than 2 yrs) that some indices impose.
3. Value weighting causes a momentum effect where the best rises to the top and then more people invest in it, making it have more weight in the index.
4. Equal weighted indices may give you better diversification over the value weight. Problem here is that you have to rebalance it and incur costs.
5. Most hedge funds use custom benchmarks because there is no standard.
6. Survivorship bias - managers with poor track records exit the business and the good remain. This bias overstates return by 1.5-3% per year. FOF's are good for this and they reduce the survivorship bias because they avoid managers destined to fail.
7. Stale price bias (not SO much of a problem for hedge funds, more important for VC) - measured correlations will come out lower than their true value. Standard deviation may be under or OVER stated than if you had actual prices.
8. Backfill bias (inclusion bias) - bad guys lay low and only the good ones will be proud to report their returns.

Front 34

Alternative Investments -
Hedge Fund Investment Characteristics

(SS13)

Back 34

1. Hedge funds are good for
i. Lowering skewness
ii. Higher kurtosis
BUT investors (are presumed to) want
i. Positive skewness
ii. Moderate kurtosis

It is possible to 'smart hedge' fund selection to reduce the problem of negative skewness.
2. Young funds outperform old funds
Small funds outperform larger ones
FOFs are a better return guide than any hedge fund index.
3. Lock-ups
If the fund has a quarterly lock-up then they have higher returns than funds with monthly lock-ups.

Front 35

Alternative Investments -
Hedge Fund Volatility and Deviation

(SS13)

Back 35

1. Hedge funds are not normally distributed, with more cases of extremely high and extremely low returns than expected. (Positive kurtosis)

USE downside deviation as an alternative risk measure
i. Only the negatives from the hurdle are used in the calculation.
ii. It thinks about the difference between good and bad volatility.

USE drawdown
i. point of maximum asset value (last time an incentive was able to be taken) and the low point.
ii. The length of time you spend in drawdown shows how well a manager recovers from losses.

Front 36

Alternative Investments -
Performance Appraisal Measures

(SS13)

Back 36

1. Sharpe: Limitations
i. time dependent
annual Sharpe > monthly Sharpe
ii. not good for asymmetrical returns
iii. Illiquid holdings bias Sharpe down because s.d is lower
iv. If there's a trend, then your sd is too low.
v. doesn't think about correlations with other assets in the portfolio
vi. Sharpe ratio can be gamed (up the time, compound returns and not the s.d, writing out of the money calls/puts, take out extreme returns or smooth)
vii. Sharpe can't be used to predict anything for Hedge fund returns.

2. Sortino
take s.d out and puts in DOWNSIDE DEVIATION
3. Gain to loss ratio
# of positive months
------------------------
# of negative months

Front 37

Alternative Investments -
Measuring consistency for hedge funds

(SS13)

Back 37

Hedge funds
i. How many months has that strategy had positive returns?
ii. If the fund is consistent it should have more positives than negatives
iii. ROLLING RETURNS are best

Front 38

Alternative Investments -
Managed Futures

(SS13)

Back 38

Managed futures
i. For accredited investors
ii. MF stick to derivative markets NOT equity, fixed income spot market the hedge funds use.
iii. MF like the MACRO stock market opportunities (not the individual)
iv. Actively managed
v. Have management fee plus incentive fee.
vi. SYSTEMATIC (rules based) or DISCRETIONARY (managers opinions) trading strategies

Front 39

Alternative Investments -
Managed Futures Investment Characteristics

(SS13)

Back 39

1. Derivatives markets are a zero sum game
2. Hedgers pay a risk premium to the CTA liquidity provider for the insurance they get.
3. Different carrying costs between investors also creates opportunities for MF traders to use short term pricing inefficiencies.
4. Most MFs use momentum strategies, like when governments intervene in ir and currency markets.
Momentum gives positive skewness to managed fund returns.
5. MF can try and win in rising and falling markets.
6. MF guys/girls can implement strategies at a lower cost than the average investor and earn returns that way.

Front 40

Commodity Forwards and Futures
Background

(SS13)

Back 40

F = S₀e^ (r-∂)T
r = continuously compounded interest rate
∂ = continuous dividend yield on the asset
1. The difference between spot and futures shows the benefits of delaying payment for and receipt of the asset.
2. Corn and soy are harvested over the summer, so increase in supply accounts for futures price going down over time (across summer)
3. Forward price goes up = CONTANGO
Forward price goes down = BACKWARDATION
4. Present value of oil depends on a futures price based on whether they are going to produce oil or not.
5. Storage = Carry

Front 41

Commodity Forwards and Futures
Equilibrium Pricing

(SS13)

Back 41

1. Synthetic commodity by combining a forward contract with a zero-coupon bond
Forward contract is costless
2. If you can't see the forward price for a commodity, valuing it is difficult.
3. A seemingly arbitrage situation may just be because the physical asset has a positive lease rate, i.e. the cost that the person with the physical asset gets. There is an income from lending an asset out.
4. Cash-and-carry where you can't loan the gold, meaning you have to buy it
Short forward 0 310.686 - S
Buy gold -$300 S
Borrow @ 0.05 $300 -$315.38
Total 0 -$4.6953
5. Cash-and-carry where you can loan the gold and EARN the lease rate
Short forward 0 310.686 -S
Buy gold (pre-lease 0.015) -$295.53 S
Borrow $295.5336 -$310.686
Total 0 0

Front 42

Commodity Forwards and Futures
Carry Markets

(SS13)

Back 42

1. Cash-and-carry logic with storage costs suggests that you will store only if you know you can get a better price in the future.
2. Financial cost of storage = interest
3. Physical cost of storage
Storage = Negative dividend
4. Convenience yield comes in from holding the physical asset, like having some inventory so that production doesn't have to stop. Only really earned by those with a business reason to hold the commodity.
Convenience yield has a no arbitrage RANGE not exact price.

Front 43

Commodity Forwards and Futures
Hedging Strategies
(SS13)

Back 43

1. Hedging with an imperfect hedge asset leads to BASIS risk
2. Basis risk is everywhere in the commodity market because of storage and transportation costs and quality differences.
3. Stack-and-roll is where you roll your futures contract forward. If the futures prices are below (backward) then rolling is profitable.
People do this because there is more liquidity in near term contracts.