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CAIA Level One > 2. Introduction to Alternative Investments > Flashcards

2. Introduction to Alternative Investments Flashcards

1
Q

Alternative Investments

A

real assets, hedge funds, commodities, private equity, and structured products

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2
Q

Real Assets

A

real estate, timberland, infrastructure, intangible assets

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3
Q

Hedge Funds

A

private investment vehicles that capitalize on investment opportunities available as a result of minimal regulatory restrictions

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4
Q

Commodities

A

standardized goods delivered to markets by many producers in large quantities

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5
Q

Private Equity

A

debt and equity securities that are not publicly traded

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6
Q

Alternative Investment Structured Products

A

collateralized debt obligations (CDOs) and credit derivatives

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7
Q

Diversifiers

A
  • also called absolute return products

- investments with low or no correlations with traditional assets

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8
Q

Lumpy Assets

A

difficult to divide and can only be traded in certain quantities

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9
Q

Normal Distribution

A

symmetrical bell-shaped distribution defined entirely by the mean and variance

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10
Q

Methodologies to Analyze Alternative Investments

A
  1. Return computational
  2. Statistical
  3. Valuation
  4. Portfolio Management
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11
Q

Return Computational Methodology

A
  • must accommodate the underlying structure
  • example: IRR
  • prices, div, interest for alts hard to observe, so may not be a good method
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12
Q

Statistical Methodology

A

methods designed to accommodate for non-normal returns

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13
Q

Valuation Methodology

A

use traditional techniques to find mispriced securities but also incorporate alternative investment specific techniques

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14
Q

Portfolio Management

A

special portfolio management techniques are needed to address issues such as liquidity and incorporating higher moments of return distribution.

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15
Q

Passive Investing

A

buying and holding a mix of securities to meet risk and return objectives, which may be expressed as a benchmark

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16
Q

Benchmark

A

standardized measure of performance for an index of portfolios with a certain level of risk and return

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17
Q

Active Management

A

attempt to create better risk and return combinations by actively buying and selling securities

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18
Q

Absolute Return Standards

A
  • evaluate investment returns against a standard of zeros or the risk free rate
  • goal is to earn return in any market condition
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19
Q

Relative Return Standards

A

evaluate investment return against a benchmark return with the goal of consistently outperforming the benchmark

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20
Q

Regulatory Structures

A

government regulation and taxation

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21
Q

Securities Structures

A

methods of cash flow securitization

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22
Q

Trading Structures

A

development and execution of trading strategies

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23
Q

Compensation Structures

A

organizational and compensation agreements

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24
Q

Institutional Structures

A

financial institutions and markets that affect the ownership and trading of a particular investment

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25
Q

Buy Side Institutions

A

asset managers that focus on acquiring appropriate securities for their investment portfolios.
examples: plan sponsor, foundation, endowment, private office, sovereign/non-federal wealth funds, alternative investment funds, separately managed account

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26
Q

Plan Sponsor

A
  • is an organization that funds a healthcare or retirement plan for qualified member
  • responsible for managing plan assets to meet its obligations
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27
Q

Foundation

A
  • nonprofit fund established for charitable purposes
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28
Q

Endowment

A
  • fund that is dedicated to providing financial support on an ongoing basis for a specific purpose
  • example: university
  • long investment horizon, high risk tolerance, little need for liquidity
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29
Q

Home Office, Private Wealth Institutions

A

manages the assets of high net individuals

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30
Q

Sovereign/ Non-Federal Wealth Fund

A
  • pools of assets owned by the government and typically managed by its central bank
  • often originate from government surplus or sales of natural resources
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31
Q

Alternative Investment Funds

A
  • typically structured as limited partnerships
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32
Q

Separately Managed Account (SMA)

A
  • portfolio that is owned by a single investor and managed according to that investors preferences by an investment advisor
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33
Q

Sell Side Institutions

A
  • focus on providing investment research and transaction execution services to their customers
  • examples: dealer bank, retail broker
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34
Q

Dealer Bank

A
  • commercial bank that both underwrites and trades investment securities and derivatives.
  • JPM, Goldman Sachs, Barclay
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35
Q

Proprietary Trading

A

dealer banks that trade for their own account

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36
Q

Retail Brokers

A
  • provide investment research and execute buy, sell and limit order
  • also prop trade
  • front, middle and back office
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37
Q

Front Office

A

meeting with clients and deciding which investment to buy, sell and hold

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38
Q

Middle Office

A
  • risk management

- serving as a communication link between front and back offices

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39
Q

Back Office

A
  • account maintenance, information technology, and trade clearance and settlement
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40
Q

Outside Service Providers

A
  • provide professional services that are vital to the formation and continued operation of alternative investment funds
  • example: prime brokers, auditors/accountants, attorneys, fund administrators, hedge fund infrastructure, consultants, depositories/custodians, commercial banks
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41
Q

Prime Broker

A

executes trades on behalf of an alternative investment manager, lends securities to short sell, provides research data, provides account statements and other documentation, and provides financing for leverage

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42
Q

Auditors/Accountants

A

review documentation, provide tax advise, outside audits

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43
Q

Attorneys

A
  • advise regarding optimal fund structure and maintains regulatory registrations
  • documents prepared include: private placement memoranda or offering documents, partnership agreement, subscription agreement, management company operating agreement
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44
Q

Private Placement Memoranda or Offering Statement

A
  • document given to potential investors and explain the potential trading strategies and associated risks
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45
Q

Partnership Agreement

A
  • document defines the legal framework for the partnership
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46
Q

Subscription Agreement

A
  • document determines if a potential investor has sufficient funds to satisfy legal requirements
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47
Q

Management Company Operating Agreement

A
  • document defines the responsibilities of the limited partnership member and the responsibilities of the fund
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48
Q

Fund Administrators

A
  • responsible for verifying operational controls, assets under management, and performance figures.
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49
Q

Hedge Fund Infrastructure

A
  • comprised of three integrated systems: platforms, software, and data providers
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50
Q

Platforms

A

operating system that allows the fund mangers to have access to both internal and external data necessary for strategy execution

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51
Q

Software

A

computer programs used by the fund that work on its chosen platform

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52
Q

Data Providers

A
  • such as index and database providers, collect market, fund, and security information and sell it to advisors, institutional investors, consultants, and other investment professionals
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53
Q

Depositories/Custodians

A

companies hold client assets and provide information services, trade clearance, and trade settlement
- Depository Trust and Clearing Corporation (DTCC) best know

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54
Q

Commercial Banks

A
  • assist with capital management, including providing the fund with loans, lines of credit, and external credit enhancement
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55
Q

Universal Banks

A
  • institutions that allow both commercial banking and investment banking
  • commonplace in Germany
  • not allowed in US
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56
Q

Keiretsu

A
  • Japan corporate sturcture
  • multiple corporations are linked together via a cross-ownership structure
  • large percentage ownership of firm by banks
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57
Q

Primary Capital Markets

A
  • sale of a new security issue
  • securitization
  • role of pcm for alts often an exit strategy
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58
Q

Securitization

A

assets are pooled together and a new securities are issued that derive their cash flows from the pool’s cash flows

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59
Q

American Depository Receipts (ADRs)

A
  • denominated in US dollars
  • traded on US markets
    • represent a claim to foreign stocks
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60
Q

Global Depository Receipts (GDRs)

A
  • issued outside of the US, and in issuers home country
  • not listed on US exchanges
  • usually denoted in US dollars
  • can be sold to US institutional investors
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61
Q

Secondary Markets

A
  • where securities trade after their initial issuance
  • provide liquidity and value information
  • structure: call markets or continuous markets
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62
Q

Call Markets

A
  • stock is only traded at specific times
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63
Q

Continuous Markets

A
  • trades occur at any time the market is open
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64
Q

Bid Ask Spread

A
  • bid price: listed first, price the dealer will pay to buy the security
  • ask price: listed second, price at which dealer will sell the security
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65
Q

Market Making

A

dealers who determine the bid-ask spread by actively trading in the secondary market and posting buy and sell prices

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66
Q

Market Orders

A

customer orders to immediately buy or sell at the best price available

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67
Q

Market Takers

A

customers who place market orders, as their orders occur at the stated bid or ask price

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68
Q

Third Markets

A
  • subset of the OTC market where nonmember investment firms can make markets in and trade exchange listed securities without going through the exchange
  • reduces transaction costs
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69
Q

Fourth Markets

A
  • electronic exchange of securities between investors without using services of broker as an intermediary
  • ECN: electronic communication network
  • matches orders by crossing
  • generally used by institutions, such as pension funds, who deal in very large volumes
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70
Q

Private Markets

A
  • common for alternatives

- be aware of lack of transparency and regulation

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71
Q

Securities Act of 1933

A
  • governs new securities issues
  • Regulation D: hedge funds exempt if securities only sold to US accredited investors and securities not marketed to the public
  • Regulation S: provides for registration exemptions if both the investment and operations of the fund occur in countries other than the US
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72
Q

Investment Company Act of 1940

A
  • instituted to regulate investment pools, such as mutual funds
    Hedge Fund Exemptions:
  • Section 3(c)(1): 100 or fewer investors in the fund
  • Section 3(c)(7): all investors in the fund are qualified purchasers and fewer than 500 total
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73
Q

Investment Advisers Act of 1940

A 
- require than investment advisors register with SEC
Exemptions:
- small advisor exception
- mid sized advisor exception
- large investment advisor
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74
Q

Form ADV

A
  • uniform form used by investment advisors to register with SEC
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75
Q

Churning

A

illegal excessive trading performed by investment managers in order to earn excess fees from investors

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76
Q

Soft Dollar Arrangements

A

investment research, products and services, and cash credits given to the investment manager or broker in return for client business

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77
Q

Regulation T Margin Rule

A
  • federal reserve rule concerning leverage

- only 50% of the value of a security can be purchased on margin

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78
Q

Undertaking for Collective Investment of Transferable Securities (UCITS) Directive

A
  • passed in 1985

- investment pools created under their guidelines could be more easily market to retail investors

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79
Q

Markets in Financial Instruments Directive (MiFiD)

A
  • 2007

- designed to more deeply integrate the financial services of the EU by establishing more uniform regulations

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80
Q

Dark Pools

A

non exchange trading systems that do not reveal current client orders

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81
Q

Alternative Investment Fund Managers (AIFM) Directive

A
  • 2011 (implemented 2013)
  • law for those that manage alts in EU
  • require fund managers to meet minimum capital requirements and obtain local regulatory approval
  • funds covered under UCITS excluded from the law
82
Q

Hedge Fund Regulations_ Australia

A
  • HF subject to same regulation as managed funds

- taxation very complex

83
Q

Hedge Fund Regulations_ Brazil

A
  • funds required to adhere to classification claim in investment policy
  • regulates investor types, required reporting, and allowable asset valuation methods
84
Q

Hedge Fund Regulations_ Canada

A
  • majority of funds are sold using linked products
  • must be registered and subject to compliance review
  • most can only be sold to accredited investors
  • annual disclosure of audits
85
Q

Hedge Fund Regulations_ Japan

A
  • minimal regulatory requirements
86
Q

Hedge Fund Regulations_ Singapore

A
  • deregulation
  • low taxes
  • government wants to increase alternatives
87
Q

Hedge Fund Regulations_ South Africa

A
  • 2008, fund managers must register
  • not allowed to market to retail investors
  • HF unregulated
  • taxation not yet finalized
88
Q

Hedge Fund Regulations_ United Arab Emirates

A
  • HF must register
  • funds subject to restrictions and regulations
  • no taxation
89
Q

Frequency Distribution

A 
- tabular presentation of statistical data
To construct:
1. Define the intervals
2. Assign the observations
3. Count the observations
90
Q

Ex post

A

returns are historical, or “after the fact”

91
Q

Ex ante

A

returns are future, or “before the fact”

92
Q

Ex post returns to predict Ex ante returns

A

if:

  1. distribution is stationary; mean and variance are constant over time
  2. large number of historical data
93
Q

Normal Distribution

A
  • Gaussian distribution
  • bell shaped probability distribution
  • mean, median, mode all equal
  • asymptotic tails
94
Q

Compounding

A
  • growth in value realized on a reinvested asset
95
Q

Log Normal Distribution

A
  • Log returns, ln(1 + R) are normally distributed, or equivalently, (1 + R) are log normally distributed
  • distribution is continuous
  • distributions ranges from -infinity to +infinity
96
Q

Autocorrelation

A
  • refers to the correlation among lagged values of a random distribution
  • will cause more extreme outcomes than predicted by normal distribution
97
Q

Second Central Moment

A
  • variance of the distribution

- measures the dispersion of the data

98
Q

Standard Deviation

A
  • square root of the variance

- used to measure volatility of the data

99
Q

Third Central Moment

A
  • measures the departure from symmetry in the distribution
  • will equal zero for symmetric distribution, such as normal distribution
  • standardized 3rd central moment = skewness
100
Q

Skewness Static

A

refers to the extent to which the distribution of data is not symmetric about its mean

101
Q

Positive Skewness

A
  • tail extends to the right

- mean > median > mode

102
Q

Negative Skewness

A
  • tail extends to the left

- mean < median < mode

103
Q

Fourth Central Moment

A
  • measures the degree of clustering in the distribution

- standardized 4 central moment = kurtosis

104
Q

Kurtosis

A
  • degree of peakedness or clustering in the data distribution
105
Q

Excess Kurtosis

A
  • kurtosis for normal distribution equals 3

- equation: kurtosis - 3

106
Q

Mesokurtic

A
  • distribution with zero excess kurtosis
107
Q

Leptokurtic

A
  • distribution that has a peak that extends above that of a normal distribution and tails that are fatter than those of a normal distribution
  • kurtosis greater than 3
108
Q

Platykurtic

A
  • distribution that has a peak that lies beneath that of a normal distribution
  • kurtosis less than 3
109
Q

Sample Mean

A

sum of all the values in a population sample, divided by the number of observations in the sample

110
Q

Sample Variance

A

measures the extent to which sampled returns deviate from the sample mean

111
Q

Standard Deviation of Normal Distribution

A
  • 68% of the data lie within one standard deviation of the mean
  • 95% of the data lie within two standard deviations of the mean
112
Q

Homoskedastic

A

variances of returns are constant over time and independently distributed

113
Q

Jarque- Bera

A
  • used to test data for departures from the normal distribution using a null hypothesis and an alternative hypothesis
  • also can tests the null hypothesis that the skewness and excess kurtosis jointly equal zero
114
Q

Target Semi-Standard Deviation

A
  • focuses solely on return that fall below a pre-specified target return
  • downside risk measure
115
Q

Shortfall Risk

A

probability that the investment return will fall below the target

116
Q

Tracking Error

A
  • measures the extent to which the investment returns deviate from the benchmark return over time
  • quantifies the uncertainty risk regarding deviations of investment returns from the benchmark return
117
Q

Drawdown

A

equals the percentage decline in asset value from its previous high

118
Q

Maximum Drawdown

A

worst percentage loss experienced from peak to trough over a specified period of time

119
Q

Value at Risk (VaR)

A
  • measure of potential loss

- worst possible loss under normal conditions over a specified period of time for a given confidence level

120
Q

Conditional VaR

A
  • known as expected shortfall or expected tail loss
  • is the loss given that the portfolio return already lies below the pre-specified “worst case” quantile return
  • conditional VaR will equal a larger loss than the VaR
121
Q

Parametric VaR

A

calculation that assumes returns are normally distributed

122
Q

Monte Carlo VaR

A
  • a model is developed that simulates values for risk factors and estimates how changes in risk factors affect the fund’s returns
  • model randomly generates possible outcome for the fund
123
Q

Heteroskedastic

A

when variances of financial data are not constant over time

124
Q

ARCH

A
  • autoregressive conditional heteroskedasticity

- used to forecast variances based on recent volatility

125
Q

GARCH

A
  • generalized autoregressive conditional
    heteroskedasticity
  • used to forecast variances based on recent unexpected returns and past variances
  • more robust method for forecasting volatility
126
Q

Benchmarking

A

process of identifying the appropriate comparison against which a portfolio’s performance is evaluated

127
Q

Normative Model

A

model that attempts to explain how investors SHOULD behave

128
Q

Positive Model

A

model that attempts to explain how investors DO behave

129
Q

Theoretical Models

A

use assumptions and logic that presumably capture underlying investment behavior

130
Q

Empirical Models

A

are based on historically observed behavior

131
Q

Applied Models

A

pragmatic in nature and are designed to address real world problems, such as how to achieve efficient diversification

132
Q

Abstract Models

A

theoretical models designed to describe behavior under hypothetical, unrealistic conditions

133
Q

Cross Sectional Models

A

describe differences across subjects for a single period of time

134
Q

Time Series Models

A

describe differences across time for a single subject

135
Q

Panel Data Sets

A
  • refer to data spanning multiple time periods and multiple securities
  • combination of cross sectional and time series
136
Q

CAPM

A
  • cross sectional equilibrium model that derives the expected return on a stock, given the expected return on the market portfolio, the stock’s beta coefficient, and the risk free rate
  • expected return on an asset is determined by it systematic risk (beta)
  • no additional return will be earned by bearing more idiosyncratic risk
  • single factor asset pricing model
137
Q

Return Attribution

A

process of ascribing returns to different components of the asset’s performance

138
Q

Assumptions of CAPM Valid, Regression Results

A
  • intercept estimate is nor significantly different from zero
  • beta estimate equals true beta of asset
  • estimates of residuals reflect effects of idiosyncratic risk
139
Q

Multi-factor Asset Pricing Model

A

relationship between expected returns of assets and the assets exposure to multiple risk factors

140
Q

Correlation Coefficient

A
  • statistical measure of the linear relationship between two variables
  • for assets it measure the strength of the relationship of returns for two assets
141
Q

Covariance

A
  • unscaled statistical measure of how two assets move together
  • expected value of the product of the deviations of the two random variables from their respective mean value
142
Q

Spearman Rank Correlation

A 
correlation of the asset returns ranks
Calculated as follows:
1. rank observations 
2. compute the differences in the ranks of each paired observation
3. calculate
143
Q

Autocorrelation

A

correlation over time for an asset

144
Q

Serial Correlation

A
  • first order autocorrelation
145
Q

Durbin-Watson

A
  • a statistical test for the existence of serial correlation
  • for large samples look at correlation between successive residuals
    if = 0, DW= 2: cannot reject null hypothesis
    if = 1, DW = 0: reject null hypothesis
    if = -1, DW = 4: reject null hypothesis
146
Q

IRR

A
  • internal rate of return
  • is the discount rate that equates the PV of an investment’s cash inflows with the PV of the investments cash outflows
  • return associated with a zero new present value
147
Q

Lifetime IRR

A

if all the cash flows are available from start to finish of the investment

148
Q

Interim or Since Inception IRR

A

IRR that assumes an appraised terminal value, period T occurs prior to the end of the investment

149
Q

Point to Point IRR

A

is the IRR if the time 0 and time T cash flows are appraised values or are other cash flows during the investment’s lifetime

150
Q

Borrowing Type Cash Flow Patterns

A

time 0 cash flow is positive and the rest of the cash flows are negative

151
Q

Multiple Sign Change Cash Flow Patterns

A

cash flows switch between positive and negative more than once

152
Q

Notional Principal

A

is the face amount on the underlying asset upon which cash flows on a derivative instrument are based

153
Q

Cash Waterfall

A

provision describing how capital is distributed to the fund’s investors

154
Q

Hurdle Rate

A
  • rate of return that must be distributed to the LP’s before general GPss can earn any incentive fees
  • typically set between 5-10%
155
Q

Soft Hurdle Rate

A

allows the GP to share in the profits if the performance of the fund is above the hurdle rate

156
Q

Hard Hurdle Rate

A

allows the GP to share only in profits in excess of the hurdle rate

157
Q

Carried Interest

A

is the percentage split of profits the fund managers earn after meeting the minimum hurdle rate and is paid on top of the management fees

158
Q

Catch up Provisions

A

give the GP a larger distribution of the profits upon passing the hurdle rate

159
Q

Vesting

A

denotes the process and timetable by which incentive payments are legally transferred to the GP

160
Q

Sharpe Ratio

A
  • equals the expected excess return earned per unit of total risk
  • key properties
    1. intuitively appealing measure of performance
    2. based on total risk
    3. sensitive to return computational interval
    4. loses usefulness when comparing portfolios with different skew and kurtosis
161
Q

Treynor Ratio

A
  • equals the expected excess return earn per unit of systematic risk
162
Q

Sortino Ratio

A

equals the portfolio excess return divided by the target semi-standard deviation

163
Q

Information Ratio

A
  • equals the portfolio’s excess return divided by the portfolio’s tracking error
  • active management return divided by the active management risk
164
Q

Return on Value at Risk

A

expected return on the portfolio divided by its value at risk, VaR

165
Q

Jensen’s Alpha

A

is the difference between the portfolio mean return and the CAPM ex post mean return

166
Q

M^2 Approach

A

risk adjusted measure of the portfolio return

- M^2 equals the expected return on the leveraged portfolio that has the same standard deviation as the market index

167
Q

Average Tracking Error

A

difference in mean returns between the portfolio and the portfolio’s benchmark

168
Q

Return on Value at Risk

A

expected return on the portfolio divided by its value at risk, VaR

169
Q

Jensen’s Alpha

A

is the difference between the portfolio mean return and the CAPM ex post mean return

170
Q

M^2 Approach

A

risk adjusted measure of the portfolio return

- M^2 equals the expected return on the leveraged portfolio that has the same standard deviation as the market index

171
Q

Average Tracking Error

A

difference in mean returns between the portfolio and the portfolio’s benchmark

172
Q

Beta

A

measure of an asset’s systematic risk

173
Q

Alpha

A

incremental return earned by an asset relative to the risk adjusted benchmark

174
Q

Ex-ante Alpha

A

anticipated incremental return

175
Q

Ex-post Alpha

A

measure of realized incremental return

176
Q

Empirical Analysis of Ex-Ante Alpha

A
  1. Identify appropriate ex post asset pricing model or benchmark
  2. Test statistical properties to determine extent to which alpha is attributable to skill
177
Q

Test of Skill vs. Luck

A
  • Invalid inferences
  • Non-normality
  • Sample selection bias
178
Q

Beta Nonstationary

A

refers to the tendency for beta to shift over time

  • beta creep
  • beta expansion
  • market timing
179
Q

Beta Creep

A

gradual increase in beta over time

180
Q

Beta Expansion

A

increases in beta as market conditions change

181
Q

Market Timing

A

attempts of the fund manager to alter beta in anticipation of changes in the market conditions

182
Q

Abnormal Return Persistence

A

tendency for idiosyncratic performance to be positively correlated over time

183
Q

Beta Drivers

A

exposure to market risk factors than compensate investors for bearing non-diversifiable market risk

184
Q

Equity Risk Premium

A

excess return that the market provides above the risk free rate

185
Q

Equity Premium Puzzle

A

tendency of the ERP to exceed its expected value based solely on risk aversion

186
Q

Passive Beta Drivers

A

return drivers form a pure play on bets

187
Q

Alpha Drivers

A

exposure to active return factors

188
Q

Product Innovators

A

are alpha drivers that create new investment opportunities

189
Q

Process Drivers

A

are beta drivers that deliver beta as cheaply and efficiently as possible

190
Q

Economic Significance

A
  • describes the extent to which a variable has a meaningful impact
  • common error to mistake statistical significance for economic significance
191
Q

Type I Error

A

occurs when rejecting a true null hypothesis

192
Q

Type II Error

A

occurs when failing to reject an untrue null hypothesis

193
Q

Bayesian Probability

A
  • equation given on exam
194
Q

Data Mining

A

practice of vigorously testing data until valid relationships are found

195
Q

Data Dredging

A

practice of overusing statistical tests to identify significant relationships with little regard for the underlying economic rationale

196
Q

Backfilling

A

updating databases by inserting returns that pre-date the date of entry

197
Q

Chumming

A

is the fishing term used to describe the process of luring big fish by scattering pieces of cheap bait

198
Q

Cumulative Return Charts

A
  • arithmetic scale

- deceiving

199
Q

Cumulative Log Return Charts

A
  • additive

- better representation of return and volatility over time

200
Q

Spurious Correlation

A

false indication of a true relationship, is coincidental or idiosyncratic, and is limited to the set of observations being examined

201
Q

Causality

A
  • one variable at least partly determines the value of another variable
  • significant beta does not imply causality

CAIA Level One (8 decks)

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