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