2. Introduction to Alternative Investments Flashcards
Alternative Investments
real assets, hedge funds, commodities, private equity, and structured products
Real Assets
real estate, timberland, infrastructure, intangible assets
Hedge Funds
private investment vehicles that capitalize on investment opportunities available as a result of minimal regulatory restrictions
Commodities
standardized goods delivered to markets by many producers in large quantities
Private Equity
debt and equity securities that are not publicly traded
Alternative Investment Structured Products
collateralized debt obligations (CDOs) and credit derivatives
Diversifiers
- also called absolute return products
- investments with low or no correlations with traditional assets
Lumpy Assets
difficult to divide and can only be traded in certain quantities
Normal Distribution
symmetrical bell-shaped distribution defined entirely by the mean and variance
Methodologies to Analyze Alternative Investments
- Return computational
- Statistical
- Valuation
- Portfolio Management
Return Computational Methodology
- must accommodate the underlying structure
- example: IRR
- prices, div, interest for alts hard to observe, so may not be a good method
Statistical Methodology
methods designed to accommodate for non-normal returns
Valuation Methodology
use traditional techniques to find mispriced securities but also incorporate alternative investment specific techniques
Portfolio Management
special portfolio management techniques are needed to address issues such as liquidity and incorporating higher moments of return distribution.
Passive Investing
buying and holding a mix of securities to meet risk and return objectives, which may be expressed as a benchmark
Benchmark
standardized measure of performance for an index of portfolios with a certain level of risk and return
Active Management
attempt to create better risk and return combinations by actively buying and selling securities
Absolute Return Standards
- evaluate investment returns against a standard of zeros or the risk free rate
- goal is to earn return in any market condition
Relative Return Standards
evaluate investment return against a benchmark return with the goal of consistently outperforming the benchmark
Regulatory Structures
government regulation and taxation
Securities Structures
methods of cash flow securitization
Trading Structures
development and execution of trading strategies
Compensation Structures
organizational and compensation agreements
Institutional Structures
financial institutions and markets that affect the ownership and trading of a particular investment
Buy Side Institutions
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
Plan Sponsor
- is an organization that funds a healthcare or retirement plan for qualified member
- responsible for managing plan assets to meet its obligations
Foundation
- nonprofit fund established for charitable purposes
Endowment
- 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
Home Office, Private Wealth Institutions
manages the assets of high net individuals
Sovereign/ Non-Federal Wealth Fund
- pools of assets owned by the government and typically managed by its central bank
- often originate from government surplus or sales of natural resources
Alternative Investment Funds
- typically structured as limited partnerships
Separately Managed Account (SMA)
- portfolio that is owned by a single investor and managed according to that investors preferences by an investment advisor
Sell Side Institutions
- focus on providing investment research and transaction execution services to their customers
- examples: dealer bank, retail broker
Dealer Bank
- commercial bank that both underwrites and trades investment securities and derivatives.
- JPM, Goldman Sachs, Barclay
Proprietary Trading
dealer banks that trade for their own account
Retail Brokers
- provide investment research and execute buy, sell and limit order
- also prop trade
- front, middle and back office
Front Office
meeting with clients and deciding which investment to buy, sell and hold
Middle Office
- risk management
- serving as a communication link between front and back offices
Back Office
- account maintenance, information technology, and trade clearance and settlement
Outside Service Providers
- 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
Prime Broker
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
Auditors/Accountants
review documentation, provide tax advise, outside audits
Attorneys
- 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
Private Placement Memoranda or Offering Statement
- document given to potential investors and explain the potential trading strategies and associated risks
Partnership Agreement
- document defines the legal framework for the partnership
Subscription Agreement
- document determines if a potential investor has sufficient funds to satisfy legal requirements
Management Company Operating Agreement
- document defines the responsibilities of the limited partnership member and the responsibilities of the fund
Fund Administrators
- responsible for verifying operational controls, assets under management, and performance figures.
Hedge Fund Infrastructure
- comprised of three integrated systems: platforms, software, and data providers
Platforms
operating system that allows the fund mangers to have access to both internal and external data necessary for strategy execution
Software
computer programs used by the fund that work on its chosen platform
Data Providers
- such as index and database providers, collect market, fund, and security information and sell it to advisors, institutional investors, consultants, and other investment professionals
Depositories/Custodians
companies hold client assets and provide information services, trade clearance, and trade settlement
- Depository Trust and Clearing Corporation (DTCC) best know
Commercial Banks
- assist with capital management, including providing the fund with loans, lines of credit, and external credit enhancement
Universal Banks
- institutions that allow both commercial banking and investment banking
- commonplace in Germany
- not allowed in US
Keiretsu
- Japan corporate sturcture
- multiple corporations are linked together via a cross-ownership structure
- large percentage ownership of firm by banks
Primary Capital Markets
- sale of a new security issue
- securitization
- role of pcm for alts often an exit strategy
Securitization
assets are pooled together and a new securities are issued that derive their cash flows from the pool’s cash flows
American Depository Receipts (ADRs)
- denominated in US dollars
- traded on US markets
- represent a claim to foreign stocks
Global Depository Receipts (GDRs)
- 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
Secondary Markets
- where securities trade after their initial issuance
- provide liquidity and value information
- structure: call markets or continuous markets
Call Markets
- stock is only traded at specific times
Continuous Markets
- trades occur at any time the market is open
Bid Ask Spread
- 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
Market Making
dealers who determine the bid-ask spread by actively trading in the secondary market and posting buy and sell prices
Market Orders
customer orders to immediately buy or sell at the best price available
Market Takers
customers who place market orders, as their orders occur at the stated bid or ask price
Third Markets
- 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
Fourth Markets
- 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
Private Markets
- common for alternatives
- be aware of lack of transparency and regulation
Securities Act of 1933
- 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
Investment Company Act of 1940
- 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
Investment Advisers Act of 1940
- require than investment advisors register with SEC Exemptions: - small advisor exception - mid sized advisor exception - large investment advisor
Form ADV
- uniform form used by investment advisors to register with SEC
Churning
illegal excessive trading performed by investment managers in order to earn excess fees from investors
Soft Dollar Arrangements
investment research, products and services, and cash credits given to the investment manager or broker in return for client business
Regulation T Margin Rule
- federal reserve rule concerning leverage
- only 50% of the value of a security can be purchased on margin
Undertaking for Collective Investment of Transferable Securities (UCITS) Directive
- passed in 1985
- investment pools created under their guidelines could be more easily market to retail investors
Markets in Financial Instruments Directive (MiFiD)
- 2007
- designed to more deeply integrate the financial services of the EU by establishing more uniform regulations
Dark Pools
non exchange trading systems that do not reveal current client orders
Alternative Investment Fund Managers (AIFM) Directive
- 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
Hedge Fund Regulations_ Australia
- HF subject to same regulation as managed funds
- taxation very complex
Hedge Fund Regulations_ Brazil
- funds required to adhere to classification claim in investment policy
- regulates investor types, required reporting, and allowable asset valuation methods
Hedge Fund Regulations_ Canada
- 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
Hedge Fund Regulations_ Japan
- minimal regulatory requirements
Hedge Fund Regulations_ Singapore
- deregulation
- low taxes
- government wants to increase alternatives
Hedge Fund Regulations_ South Africa
- 2008, fund managers must register
- not allowed to market to retail investors
- HF unregulated
- taxation not yet finalized
Hedge Fund Regulations_ United Arab Emirates
- HF must register
- funds subject to restrictions and regulations
- no taxation
Frequency Distribution
- tabular presentation of statistical data To construct: 1. Define the intervals 2. Assign the observations 3. Count the observations
Ex post
returns are historical, or “after the fact”
Ex ante
returns are future, or “before the fact”
Ex post returns to predict Ex ante returns
if:
- distribution is stationary; mean and variance are constant over time
- large number of historical data
Normal Distribution
- Gaussian distribution
- bell shaped probability distribution
- mean, median, mode all equal
- asymptotic tails
Compounding
- growth in value realized on a reinvested asset
Log Normal Distribution
- 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
Autocorrelation
- refers to the correlation among lagged values of a random distribution
- will cause more extreme outcomes than predicted by normal distribution
Second Central Moment
- variance of the distribution
- measures the dispersion of the data
Standard Deviation
- square root of the variance
- used to measure volatility of the data
Third Central Moment
- measures the departure from symmetry in the distribution
- will equal zero for symmetric distribution, such as normal distribution
- standardized 3rd central moment = skewness
Skewness Static
refers to the extent to which the distribution of data is not symmetric about its mean
Positive Skewness
- tail extends to the right
- mean > median > mode
Negative Skewness
- tail extends to the left
- mean < median < mode
Fourth Central Moment
- measures the degree of clustering in the distribution
- standardized 4 central moment = kurtosis
Kurtosis
- degree of peakedness or clustering in the data distribution
Excess Kurtosis
- kurtosis for normal distribution equals 3
- equation: kurtosis - 3
Mesokurtic
- distribution with zero excess kurtosis
Leptokurtic
- 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
Platykurtic
- distribution that has a peak that lies beneath that of a normal distribution
- kurtosis less than 3
Sample Mean
sum of all the values in a population sample, divided by the number of observations in the sample
Sample Variance
measures the extent to which sampled returns deviate from the sample mean
Standard Deviation of Normal Distribution
- 68% of the data lie within one standard deviation of the mean
- 95% of the data lie within two standard deviations of the mean
Homoskedastic
variances of returns are constant over time and independently distributed
Jarque- Bera
- 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
Target Semi-Standard Deviation
- focuses solely on return that fall below a pre-specified target return
- downside risk measure
Shortfall Risk
probability that the investment return will fall below the target
Tracking Error
- 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
Drawdown
equals the percentage decline in asset value from its previous high
Maximum Drawdown
worst percentage loss experienced from peak to trough over a specified period of time
Value at Risk (VaR)
- measure of potential loss
- worst possible loss under normal conditions over a specified period of time for a given confidence level
Conditional VaR
- 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
Parametric VaR
calculation that assumes returns are normally distributed
Monte Carlo VaR
- 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
Heteroskedastic
when variances of financial data are not constant over time
ARCH
- autoregressive conditional heteroskedasticity
- used to forecast variances based on recent volatility
GARCH
- generalized autoregressive conditional
heteroskedasticity - used to forecast variances based on recent unexpected returns and past variances
- more robust method for forecasting volatility
Benchmarking
process of identifying the appropriate comparison against which a portfolio’s performance is evaluated
Normative Model
model that attempts to explain how investors SHOULD behave
Positive Model
model that attempts to explain how investors DO behave
Theoretical Models
use assumptions and logic that presumably capture underlying investment behavior
Empirical Models
are based on historically observed behavior
Applied Models
pragmatic in nature and are designed to address real world problems, such as how to achieve efficient diversification
Abstract Models
theoretical models designed to describe behavior under hypothetical, unrealistic conditions
Cross Sectional Models
describe differences across subjects for a single period of time
Time Series Models
describe differences across time for a single subject
Panel Data Sets
- refer to data spanning multiple time periods and multiple securities
- combination of cross sectional and time series
CAPM
- 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
Return Attribution
process of ascribing returns to different components of the asset’s performance
Assumptions of CAPM Valid, Regression Results
- intercept estimate is nor significantly different from zero
- beta estimate equals true beta of asset
- estimates of residuals reflect effects of idiosyncratic risk
Multi-factor Asset Pricing Model
relationship between expected returns of assets and the assets exposure to multiple risk factors
Correlation Coefficient
- statistical measure of the linear relationship between two variables
- for assets it measure the strength of the relationship of returns for two assets
Covariance
- 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
Spearman Rank Correlation
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
Autocorrelation
correlation over time for an asset
Serial Correlation
- first order autocorrelation
Durbin-Watson
- 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
IRR
- 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
Lifetime IRR
if all the cash flows are available from start to finish of the investment
Interim or Since Inception IRR
IRR that assumes an appraised terminal value, period T occurs prior to the end of the investment
Point to Point IRR
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
Borrowing Type Cash Flow Patterns
time 0 cash flow is positive and the rest of the cash flows are negative
Multiple Sign Change Cash Flow Patterns
cash flows switch between positive and negative more than once
Notional Principal
is the face amount on the underlying asset upon which cash flows on a derivative instrument are based
Cash Waterfall
provision describing how capital is distributed to the fund’s investors
Hurdle Rate
- rate of return that must be distributed to the LP’s before general GPss can earn any incentive fees
- typically set between 5-10%
Soft Hurdle Rate
allows the GP to share in the profits if the performance of the fund is above the hurdle rate
Hard Hurdle Rate
allows the GP to share only in profits in excess of the hurdle rate
Carried Interest
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
Catch up Provisions
give the GP a larger distribution of the profits upon passing the hurdle rate
Vesting
denotes the process and timetable by which incentive payments are legally transferred to the GP
Sharpe Ratio
- 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
Treynor Ratio
- equals the expected excess return earn per unit of systematic risk
Sortino Ratio
equals the portfolio excess return divided by the target semi-standard deviation
Information Ratio
- equals the portfolio’s excess return divided by the portfolio’s tracking error
- active management return divided by the active management risk
Return on Value at Risk
expected return on the portfolio divided by its value at risk, VaR
Jensen’s Alpha
is the difference between the portfolio mean return and the CAPM ex post mean return
M^2 Approach
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
Average Tracking Error
difference in mean returns between the portfolio and the portfolio’s benchmark
Return on Value at Risk
expected return on the portfolio divided by its value at risk, VaR
Jensen’s Alpha
is the difference between the portfolio mean return and the CAPM ex post mean return
M^2 Approach
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
Average Tracking Error
difference in mean returns between the portfolio and the portfolio’s benchmark
Beta
measure of an asset’s systematic risk
Alpha
incremental return earned by an asset relative to the risk adjusted benchmark
Ex-ante Alpha
anticipated incremental return
Ex-post Alpha
measure of realized incremental return
Empirical Analysis of Ex-Ante Alpha
- Identify appropriate ex post asset pricing model or benchmark
- Test statistical properties to determine extent to which alpha is attributable to skill
Test of Skill vs. Luck
- Invalid inferences
- Non-normality
- Sample selection bias
Beta Nonstationary
refers to the tendency for beta to shift over time
- beta creep
- beta expansion
- market timing
Beta Creep
gradual increase in beta over time
Beta Expansion
increases in beta as market conditions change
Market Timing
attempts of the fund manager to alter beta in anticipation of changes in the market conditions
Abnormal Return Persistence
tendency for idiosyncratic performance to be positively correlated over time
Beta Drivers
exposure to market risk factors than compensate investors for bearing non-diversifiable market risk
Equity Risk Premium
excess return that the market provides above the risk free rate
Equity Premium Puzzle
tendency of the ERP to exceed its expected value based solely on risk aversion
Passive Beta Drivers
return drivers form a pure play on bets
Alpha Drivers
exposure to active return factors
Product Innovators
are alpha drivers that create new investment opportunities
Process Drivers
are beta drivers that deliver beta as cheaply and efficiently as possible
Economic Significance
- describes the extent to which a variable has a meaningful impact
- common error to mistake statistical significance for economic significance
Type I Error
occurs when rejecting a true null hypothesis
Type II Error
occurs when failing to reject an untrue null hypothesis
Bayesian Probability
- equation given on exam
Data Mining
practice of vigorously testing data until valid relationships are found
Data Dredging
practice of overusing statistical tests to identify significant relationships with little regard for the underlying economic rationale
Backfilling
updating databases by inserting returns that pre-date the date of entry
Chumming
is the fishing term used to describe the process of luring big fish by scattering pieces of cheap bait
Cumulative Return Charts
- arithmetic scale
- deceiving
Cumulative Log Return Charts
- additive
- better representation of return and volatility over time
Spurious Correlation
false indication of a true relationship, is coincidental or idiosyncratic, and is limited to the set of observations being examined
Causality
- one variable at least partly determines the value of another variable
- significant beta does not imply causality
