2.1 What Is an Alternative Investment?

Question 1

What Is an Alternative Investment?

Answer 1

Any investment that is not simply a long position in traditional investments

Question 2

What is a Traditional Investment

Answer 2

It includes publicly traded equities, fixed-income securities, and cash.

Question 3

Define Investment

Answer 3

Deferred consumption. Any net outlay of cash made with the prospect of receiving future benefits might be considered an investment.

Question 4

What is Institutional Quality Investment

Answer 4

Investments that FIs such as pension funds or endowments may include in their holdings; expected to deliver reasonable returns at acceptable level of risk.

Question 5

What are the four types of Alternative Investments?

Answer 5

Real Assets; Hedge Funds; Private equity and credit; Structures Products

Question 6

List four major types of real assets other than land and other types of real estate.

Answer 6

Natural resources, commodities, infrastructure and intellectual property

Question 7

How do you distinguish real assets from financial assets? List three ways.

Answer 7

(1) Real assets involve ownership of non-financial assets rather than financial assets (like securities of enterprises). (2) Tend to represent more direct claim on consumption. (3) Tend to do so with less reliance on factors that create value such as intangible asset or managerial skill.

Question 8

What is a financial asset?

Answer 8

It is not a real asset. It is a claim on cash flows, such as a share of stock or a bond. Intangible assets, such as technology, directly facilitate production, thereby creating increased value.

Question 9

What is a hedge fund?

Answer 9

Privately organised investment vehicle that uses less regulated nature to generate investment return, potentially using strategies such as derivatives or leverage that traditional vehicles cannot use.

Question 10

What are the four types of Private Equity / Private Credit strategies listed?

Answer 10

Venture Capital; Leveraged Buyouts; Mezzanine debt; Distressed Debt

Question 11

Define Leveraged Buyouts (LBO)

Answer 11

Equity is purchased using a small amount of capital and a large amount of borrowed funds. Borrowed funds secured by asset or cash flow of company. Potential goals: tax advantages of financing, improving operating efficiency and profitability.

Question 12

What is Mezzanine Debt, and what the three types of mezzanine debt?

Answer 12

Debt between senior secured and equity, e.g. preferred stock, convertible debt, hybrid securities that includes equity kicker.

Question 13

What is Distressed Debt?

Answer 13

Debt of companies that have filed or are likely to file for bankruptcy protection.

Question 14

What is a Structured Product, and what are the two common types of SP?

Answer 14

Instruments created to exhibit a particular return, risk, taxation etc. It generates unique cash flows as a result of partitioning cash flows. Structuring of financing sources may create option-like characteristics. Types (1) Collateralised Debt Obligations which partition returns into tranches, (2) Credit Derivatives which allows credit protection buyer to transfer credit risk to seller.

Question 15

What are the two traits of an Absolute Return Product?

Answer 15

(1) Low return correlation to Traditional Asset, (2) Performance analysed on absolute rather than relative basis

Question 16

What does Illiquidity mean?

Answer 16

Trades with low volumes high implies that returns are difficult to observe due to lack of trading, and price may be affected by a few market participants.

Question 17

What is Efficiency, and what is the impact of Inefficiency?

Answer 17

Efficiency refers to ability of market prices to reflect all available information. Impact of inefficiency would be deviation of actual prices from valuations in an efficient market.

Question 18

What are the three causes of non-normality of returns?

Answer 18

(1) Illiquid with long term intervals causing return to be poorly approximated using normal distribution, (2) derivatives structured to be non-linearly related to security, (3) trading structures that goes long/short quickly.

Question 19

How do regulatory factors affect role in alternative investments?

Answer 19

Structured to avoid higher levels of Regulation; or to transform cash flows to reduce Taxation

Question 20

How are cash flow claims partitioned?

Answer 20

Securitisation into different traceable units. Cash flows can be partitioned into financial claims with different levels of risks or cash flows etc.

Question 21

How do compensation structures affect alternative investments?

Answer 21

Structures to reward managers may have implications for agency costs generated by owner-manager relationships

Question 22

What is an incomplete market and how does it affect an investment?

Answer 22

An incomplete market refers to the lack of investment opportunities that causes market participants to be unable to implement an investment strategy that satisfies their exact preferences such as risk preferences.

Question 23

What are the three ways to differentiate traditional vs alternative assets?

Answer 23

(1) Illiquid and not available through 40 Act Funds, (2) Returns not dominated by underlying real assets, (3) Extend to which product offers nontraditional risk and return exposures, requires investment management tools different from traditional ones

Question 24

What are the two pillars of alternative asset management? E____ A____; E___ R____

Answer 24

(1) Empirical Analysis of historical risk adjusted return, (2) Economic Reasoning

Question 25

Name the assets that are often characterized as traditional by some and as alternatives by others for each of the following categories: hedge funds, private equity and real assets.

Answer 25

Hedge Funds – liquid alternative mutual funds
Private Equity – closed-end funds with illiquid holdings
Real Assets – public real estate and public equities of corporations with performance dominated by stable positions in real assets

Question 26

Name four major methods of analysis that distinguish the analysis of alternative investments from the analysis of traditional investments.

Answer 26

1. Return Computation Methods
2. Statistical Methods
3. Valuation Methods
4. Portfolio Management Methods

Question 26

Name the four return characteristics that differentiate traditional and alternative investments.

Answer 26

1. Diversification
2. Illiquidity
3. Inefficiency
4. Nonnormality

Question 26

Define active management.

Answer 26

Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return.

Question 27

Approximately when did average-quality corporate bonds and international equities become commonly viewed as institutional-quality investments in the United States?

Answer 27

Between 1950 to 1980

Question 28

What distinguishes use of the term pure arbitrage from the more general usage of the term arbitrage?

Answer 28

Pure arbitrage is risk-free, while arbitrage, as a more general term, is not risk-free. Pure arbitrage is an attempt to earn risk-free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets. Whereas, arbitrage is used to represent efforts to earn superior returns even when risk is present because the long and short positions are not in identical assets or are not held over the same time period.