2. Introduction to Alternative Investments Flashcards by D K

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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

Outside Service Providers

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

Churning

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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 Company Act of 1940

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

Securitization

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refer to data spanning multiple time periods and multiple securities - combination of cross sectional and time series

Panel Data Sets

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returns are historical, or “after the fact”

Ex post

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

Notional Principal

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methods of cash flow securitization

Securities Structures

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

Alternative Investments

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non exchange trading systems that do not reveal current client orders

Dark Pools

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

Third Central Moment

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

Separately Managed Account (SMA)

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

Sample Variance

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degree of peakedness or clustering in the data distribution

Kurtosis

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growth in value realized on a reinvested asset

Compounding

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account maintenance, information technology, and trade clearance and settlement

Back Office

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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

Leptokurtic

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

Return Computational Methodology

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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

CAPM

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

Frequency Distribution

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sale of a new security issue - securitization - role of pcm for alts often an exit strategy

Primary Capital Markets

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uniform form used by investment advisors to register with SEC

Form ADV

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variances of returns are constant over time and independently distributed

Homoskedastic

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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

Bid Ask Spread

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

Return on Value at Risk

# reversed prompt - intercept estimate is nor significantly different from zero - beta estimate equals true beta of asset - estimates of residuals reflect effects of idiosyncratic risk

Assumptions of CAPM Valid, Regression Results

# reversed prompt - such as index and database providers, collect market, fund, and security information and sell it to advisors, institutional investors, consultants, and other investment professionals

Data Providers

# reversed prompt - tail extends to the right - mean \> median \> mode

Positive Skewness

# reversed prompt -Japan corporate sturcture - multiple corporations are linked together via a cross-ownership structure - large percentage ownership of firm by banks

Keiretsu

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

Borrowing Type Cash Flow Patterns

# reversed prompt -pools of assets owned by the government and typically managed by its central bank - often originate from government surplus or sales of natural resources

Sovereign/ Non-Federal Wealth Fund

# reversed prompt - funds required to adhere to classification claim in investment policy - regulates investor types, required reporting, and allowable asset valuation methods

Hedge Fund Regulations\_ Brazil

# reversed prompt 1. Identify appropriate ex post asset pricing model or benchmark 2. Test statistical properties to determine extent to which alpha is attributable to skill

Empirical Analysis of Ex-Ante Alpha

# reversed prompt - deregulation - low taxes - government wants to increase alternatives

Hedge Fund Regulations\_ Singapore

# reversed prompt tendency for idiosyncratic performance to be positively correlated over time

Abnormal Return Persistence

# reversed prompt occurs when failing to reject an untrue null hypothesis

Type II Error

# reversed prompt return drivers form a pure play on bets

Passive Beta Drivers

# reversed prompt - provide investment research and execute buy, sell and limit order - also prop trade - front, middle and back office

Retail Brokers

# reversed prompt is the difference between the portfolio mean return and the CAPM ex post mean return

Jensen's Alpha

# reversed prompt - 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

Sharpe Ratio

# reversed prompt - document defines the responsibilities of the limited partnership member and the responsibilities of the fund

Management Company Operating Agreement

# reversed prompt practice of vigorously testing data until valid relationships are found

Data Mining

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

Data Dredging

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

Catch up Provisions

# reversed prompt - 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

Third Markets

# reversed prompt review documentation, provide tax advise, outside audits

Auditors/Accountants

# reversed prompt occurs when rejecting a true null hypothesis

Type I Error

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

Platforms

# reversed prompt exposure to active return factors

Alpha Drivers

# reversed prompt standardized goods delivered to markets by many producers in large quantities

Commodities

# reversed prompt - document determines if a potential investor has sufficient funds to satisfy legal requirements

Subscription Agreement

# reversed prompt - minimal regulatory requirements

Hedge Fund Regulations\_ Japan

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

Market Making

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

Relative Return Standards

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

Market Orders

# reversed prompt - kurtosis for normal distribution equals 3 - equation: kurtosis - 3

Excess Kurtosis

# reversed prompt - variance of the distribution - measures the dispersion of the data

Second Central Moment

# reversed prompt - 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

Global Depository Receipts (GDRs)

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

Spurious Correlation

# reversed prompt use assumptions and logic that presumably capture underlying investment behavior

Theoretical Models

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

Market Timing

# reversed prompt - 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\_ Canada

# reversed prompt - 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

Alternative Investment Fund Managers (AIFM) Directive

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

Interim or Since Inception IRR

# reversed prompt equals the percentage decline in asset value from its previous high

Drawdown

# reversed prompt collateralized debt obligations (CDOs) and credit derivatives

Alternative Investment Structured Products

# reversed prompt - 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

Jarque- Bera

# reversed prompt measure of realized incremental return

Ex-post Alpha

# reversed prompt gradual increase in beta over time

Beta Creep

# reversed prompt - generalized autoregressive conditional heteroskedasticity - used to forecast variances based on recent unexpected returns and past variances - more robust method for forecasting volatility

GARCH

# reversed prompt difference in mean returns between the portfolio and the portfolio's benchmark

Average Tracking Error

# reversed prompt - HF must register - funds subject to restrictions and regulations - no taxation

Hedge Fund Regulations\_ United Arab Emirates

# reversed prompt - autoregressive conditional heteroskedasticity - used to forecast variances based on recent volatility

ARCH

# reversed prompt 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

Prime Broker

# reversed prompt methods designed to accommodate for non-normal returns

Statistical Methodology

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

Portfolio Management

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

Return on Value at Risk

# reversed prompt - 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

Conditional VaR

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

Market Takers

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

Backfilling

# reversed prompt - HF subject to same regulation as managed funds - taxation very complex

Hedge Fund Regulations\_ Australia

# reversed prompt is the difference between the portfolio mean return and the CAPM ex post mean return

Jensen's Alpha

# reversed prompt - denominated in US dollars - traded on US markets \*\* represent a claim to foreign stocks

American Depository Receipts (ADRs)

# reversed prompt - rate of return that must be distributed to the LP's before general GPss can earn any incentive fees - typically set between 5-10%

Hurdle Rate

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

Alpha

# reversed prompt - statistical measure of the linear relationship between two variables - for assets it measure the strength of the relationship of returns for two assets

Correlation Coefficient

# reversed prompt - comprised of three integrated systems: platforms, software, and data providers

Hedge Fund Infrastructure

# reversed prompt - 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

IRR

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

Active Management

# reversed prompt - is an organization that funds a healthcare or retirement plan for qualified member - responsible for managing plan assets to meet its obligations

Plan Sponsor

# reversed prompt - 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

Securities Act of 1933

# reversed prompt - 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

Tracking Error

# reversed prompt are based on historically observed behavior

Empirical Models

# reversed prompt manages the assets of high net individuals

Home Office, Private Wealth Institutions

# reversed prompt if: 1. distribution is stationary; mean and variance are constant over time 2. large number of historical data

Ex post returns to predict Ex ante returns

# reversed prompt -evaluate investment returns against a standard of zeros or the risk free rate - goal is to earn return in any market condition

Absolute Return Standards

# reversed prompt process of identifying the appropriate comparison against which a portfolio's performance is evaluated

Benchmarking

# reversed prompt - arithmetic scale - deceiving

Cumulative Return Charts

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

Maximum Drawdown

# reversed prompt calculation that assumes returns are normally distributed

Parametric VaR

# reversed prompt -68% of the data lie within one standard deviation of the mean - 95% of the data lie within two standard deviations of the mean

Standard Deviation of Normal Distribution

# reversed prompt - one variable at least partly determines the value of another variable - significant beta does not imply causality

Causality

# reversed prompt -also called absolute return products - investments with low or no correlations with traditional assets

Diversifiers

# reversed prompt - 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

Covariance

# reversed prompt - describes the extent to which a variable has a meaningful impact - common error to mistake statistical significance for economic significance

Economic Significance

# reversed prompt - first order autocorrelation

Serial Correlation

# reversed prompt anticipated incremental return

Ex-ante Alpha

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

Sortino Ratio

# reversed prompt 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

Carried Interest

# reversed prompt - Invalid inferences - Non-normality - Sample selection bias

Test of Skill vs. Luck

# reversed prompt - responsible for verifying operational controls, assets under management, and performance figures.

Fund Administrators

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

Chumming

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

Beta Drivers

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

Passive Investing

# reversed prompt government regulation and taxation

Regulatory Structures

# reversed prompt - equation given on exam

Bayesian Probability

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

Soft Hurdle Rate

# reversed prompt increases in beta as market conditions change

Beta Expansion

# reversed prompt real estate, timberland, infrastructure, intangible assets

Real Assets

# reversed prompt model that attempts to explain how investors DO behave

Positive Model

# reversed prompt - focus on providing investment research and transaction execution services to their customers - examples: dealer bank, retail broker

Sell Side Institutions

# reversed prompt - Gaussian distribution - bell shaped probability distribution - mean, median, mode all equal - asymptotic tails

Normal Distribution

# reversed prompt - assist with capital management, including providing the fund with loans, lines of credit, and external credit enhancement

Commercial Banks

# reversed prompt - tail extends to the left - mean \< median \< mode

Negative Skewness

# reversed prompt are beta drivers that deliver beta as cheaply and efficiently as possible

Process Drivers

# reversed prompt refers to the tendency for beta to shift over time -beta creep -beta expansion -market timing

Beta Nonstationary

# reversed prompt - 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

Durbin-Watson

# reversed prompt - 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

Endowment

# reversed prompt provision describing how capital is distributed to the fund's investors

Cash Waterfall

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

Benchmark

# reversed prompt - nonprofit fund established for charitable purposes

Foundation

# reversed prompt - 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

Log Normal Distribution

# reversed prompt - trades occur at any time the market is open

Continuous Markets

# reversed prompt - commercial bank that both underwrites and trades investment securities and derivatives. - JPM, Goldman Sachs, Barclay

Dealer Bank

# reversed prompt model that attempts to explain how investors SHOULD behave

Normative Model

# reversed prompt - 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

Monte Carlo VaR

# reversed prompt organizational and compensation agreements

Compensation Structures

# reversed prompt - risk management - serving as a communication link between front and back offices

Middle Office

# reversed prompt - 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

Fourth Markets

# reversed prompt - measure of potential loss - worst possible loss under normal conditions over a specified period of time for a given confidence level

Value at Risk (VaR)

# reversed prompt 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

M^2 Approach

# reversed prompt debt and equity securities that are not publicly traded

Private Equity

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

Depositories/Custodians

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

Skewness Static

# reversed prompt 1. Return computational 2. Statistical 3. Valuation 4. Portfolio Management

Methodologies to Analyze Alternative Investments

# reversed prompt measure of an asset's systematic risk

Beta

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

Applied Models

# reversed prompt 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

M^2 Approach

# reversed prompt - require than investment advisors register with SEC Exemptions: - small advisor exception - mid sized advisor exception - large investment advisor

Investment Advisers Act of 1940

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

Normal Distribution

# reversed prompt - document given to potential investors and explain the potential trading strategies and associated risks

Private Placement Memoranda or Offering Statement

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

Lifetime IRR

# reversed prompt - typically structured as limited partnerships

Alternative Investment Funds

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

Hedge Funds

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

Equity Premium Puzzle

# reversed prompt - distribution that has a peak that lies beneath that of a normal distribution - kurtosis less than 3

Platykurtic

# reversed prompt describe differences across subjects for a single period of time

Cross Sectional Models

# reversed prompt cash flows switch between positive and negative more than once

Multiple Sign Change Cash Flow Patterns

# reversed prompt - document defines the legal framework for the partnership

Partnership Agreement

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

Software

# reversed prompt - federal reserve rule concerning leverage - only 50% of the value of a security can be purchased on margin

Regulation T Margin Rule

# reversed prompt - 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

Attorneys

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

Valuation Methodology

# reversed prompt - where securities trade after their initial issuance - provide liquidity and value information - structure: call markets or continuous markets

Secondary Markets

# reversed prompt difference in mean returns between the portfolio and the portfolio's benchmark

Average Tracking Error

# reversed prompt describe differences across time for a single subject

Time Series Models

# reversed prompt - institutions that allow both commercial banking and investment banking - commonplace in Germany - not allowed in US

Universal Banks

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

Hard Hurdle Rate

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

Vesting

# reversed prompt when variances of financial data are not constant over time

Heteroskedastic

# reversed prompt - equals the portfolio's excess return divided by the portfolio's tracking error - active management return divided by the active management risk

Information Ratio

# reversed prompt - square root of the variance - used to measure volatility of the data

Standard Deviation

# reversed prompt development and execution of trading strategies

Trading Structures

# reversed prompt correlation over time for an asset

Autocorrelation

# reversed prompt returns are future, or "before the fact"

Ex ante

# reversed prompt - additive - better representation of return and volatility over time

Cumulative Log Return Charts

# reversed prompt - passed in 1985 - investment pools created under their guidelines could be more easily market to retail investors

Undertaking for Collective Investment of Transferable Securities (UCITS) Directive

# reversed prompt - focuses solely on return that fall below a pre-specified target return - downside risk measure

Target Semi-Standard Deviation

# reversed prompt - 2008, fund managers must register - not allowed to market to retail investors - HF unregulated - taxation not yet finalized

Hedge Fund Regulations\_ South Africa

# reversed prompt process of ascribing returns to different components of the asset's performance

Return Attribution

# reversed prompt 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

Spearman Rank Correlation

# reversed prompt probability that the investment return will fall below the target

Shortfall Risk

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

Institutional Structures

# reversed prompt excess return that the market provides above the risk free rate

Equity Risk Premium

# reversed prompt dealer banks that trade for their own account

Proprietary Trading

# reversed prompt 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

Buy Side Institutions

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

Sample Mean

# reversed prompt - 2007 - designed to more deeply integrate the financial services of the EU by establishing more uniform regulations

Markets in Financial Instruments Directive (MiFiD)

# reversed prompt theoretical models designed to describe behavior under hypothetical, unrealistic conditions

Abstract Models

# reversed prompt - distribution with zero excess kurtosis

Mesokurtic

# reversed prompt - refers to the correlation among lagged values of a random distribution - will cause more extreme outcomes than predicted by normal distribution

Autocorrelation

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

Multi-factor Asset Pricing Model

# reversed prompt - common for alternatives - be aware of lack of transparency and regulation

Private Markets

# reversed prompt are alpha drivers that create new investment opportunities

Product Innovators

# reversed prompt - equals the expected excess return earn per unit of systematic risk

Treynor Ratio

# reversed prompt - stock is only traded at specific times

Call Markets

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

Front Office

# reversed prompt - measures the degree of clustering in the distribution - standardized 4 central moment = kurtosis

Fourth Central Moment

# reversed prompt 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

Point to Point IRR

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

Soft Dollar Arrangements

# reversed prompt difficult to divide and can only be traded in certain quantities

Lumpy Assets