(50) Introduction to Alternative Investments

Question 1

LOS 59. a: Compare alternative investments with traditional investments. Compare traditional investments to alternative investments.

Answer 1

“Traditional investments” refers to long-only positions in stocks, bonds, and cash. “Alternative investments” refers to some types of assets such as real estate, commodities, and various collectables, as well as some specific structures of investment vehicles.

Question 2

LOS 59. a: Compare alternative investments with traditional investments. Define the following structures:

• Hedge fund, private equity funds, and venture capital funds
• Real estate investment trusts (REITs)
• ETFs

Answer 2

Hedge fund and private equity funds (including venture capital funds) are often structured as limited partnerships; real estate investment trusts (REITs) are similar to mutual funds; and ETFs can contain alternative investments as well.

Question 3

LOS 59. a: Compare alternative investments with traditional investments. Define the characteristics alternative invests typically have compared to traditional investments.

Answer 3

Compared to traditional investments, alternative investments typically have:

• lower liquidity;
• less regulation and disclosure;
• higher management fees and more specialized management;
• potentially diversification benefits;
• more use of leverage, use of derivatives;
• potentially higher returns;
• limited and possibly biased historical returns data;
• problematic historical risk measures; and;
• unique legal and tax considerations.

Question 4

LOS 59. b: Describe categories of alternative investments. Define hedge funds

Answer 4

Hedge funds are investment companies that use a variety of strategies and maybe highly leveraged, use long and short positions, and use derivatives.

Question 5

LOS 59. b: Describe categories of alternative investments. Define private equity

Answer 5

Private equity funds usually invest in the equity of private companies or companies wanting to become private, financing their assets with high levels of debt. The category also includes venture capital funds, which provide capital to companies early in their development

Question 6

LOS 59. b: Describe categories of alternative investments. Define real estate

Answer 6

Real estate as an asset class includes residential and commercial real estate, individual mortgages, and pools of mortgages or properties. It includes direct investment in single properties or loans as well as indirect investment in limited partnerships, which are private securities, and mortgage-backed securities and real estate investment trusts, which are publicly traded.

Question 7

LOS 59. b: Describe categories of alternative investments. Define commodities

Answer 7

Commodities refers to physical assets such as agriculture products, metals, oil and gas, and other raw materials used in production. Commodities markets exposure can provide an inflation hedge and diversification benefits.

Question 8

LOS 59. b: Describe categories of alternative investments. Define infrastructure

Answer 8

Infrastructure refers to long-lived assets that provide public services and are often built or operated by governments. Various types of collectibles, such as cars, wines, and art, are considered alternative investments as well.

Question 9

LOS 59. c: Describe potential benefits of alternative investments in the context of portfolio management.

Answer 9

The primary motivation for adding alternative investments to a portfolio is to reduce portfolio risk based on the less-than-perfect correlation between alternative asset returns and traditional asset returns. For many alternative investments, the expertise of the manager can be an important determinant of returns.

Question 10

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, what is an event-driven strategy?

Answer 10

Event-driven strategies include merger arbitrage, distressed/restructuring, activist shareholder and special situations.

Question 11

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, what is a relative value strategy?

Answer 11

Relative value strategies seek profits from unusual pricing issues.

Question 12

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, what is a macro hedge strategy?

Answer 12

Macro hedge strategies are “bottom up” strategies that take long and short positions.

Question 13

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, what is a equity hedge strategy?

Answer 13

Equity hedge strategies are “bottom down” strategies that take long and short positions in equities and equity derivatives. Strategies include market neutral, fundamental growth, fundamental value, quantitative direction, short bias, and sector specific.

Question 14

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, what are the potential risks?

Answer 14

In period of financial crisis, the correlation of returns between global equities and hedge funds tend to increase, which limits hedge funds’ effectiveness as a diversifying asset class.

Question 15

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, an investor who chooses a fund of funds as an alternative to a single hedge fund is most likely to benefit form what?

Answer 15

A fund of funds manager is expected to provide more due diligence and better redemption terms. Funds of funds charge an additional layer of fees. Investing in fund of funds may provide more diversification but may not necessarily provide higher returns.

Question 16

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under hedge funds, what are the due diligence factors?

Answer 16

Due diligence factors for hedge funds are:

• investment strategy,
• investment process,
• competitive advantage,
• track record,
• longevity of fund, and;
• size (assets under management).

Other qualitative factors include management style, key person risk, reputation, investor relations, growth plans, and management of systemic risk.

Question 17

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under private equity, what are the strategies?

Answer 17

Leverage buyouts (LBOs) and venture capital are the two dominant strategies. Other strategies include developmental capital and distressed securities.

Question 18

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under private equity, what are the types of leverage buy outs (LBOs)?

Answer 18

Types of LBOs include:

• management buyouts, in which the existing management team is involved in the purchase, and
• management buy ins, in which an external management team replaces the existing management.

Question 19

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under private equity, what are the stages of venture capital investing?

Answer 19

Stages of venture capital investing include:

• the formative stage (composed of the angel investing, seed, and early stages);
• the later stage (expansion); and;
• the mezzanine stage (prepare for IPO).

Question 20

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under private equity, what are the methods for exiting investments in portfolio companies?

Answer 20

Methods for exiting investments in portfolio companies include:

• trade sale (sell to a competitor or another strategic buyer);
• IPO (sell some or all shares to investors);
• recapitalization (issue portfolio company debt);
• secondary sale (sell to another private equity firm or other investors);
• or write-off/liquidation.

Question 21

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under private equity, what are the diversification benefits?

Answer 21

Private equity has some historical record of potential diversification benefits. An investor must identify top performing private equity managers to benefit from private equity.

Question 22

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under private equity, what are the due diligence factors?

Answer 22

Due diligence factors for private equity include:

• the manager’s experience
• valuation methods used
• fee structure, and;
• drawdown procedures for committed capital.

Question 23

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under real estate, what are the reasons to invest in real estate?

Answer 23

Reasons to invest in real estate include:

• potential long-term total returns,
• income from rent payments,
• diversification benefits, and;
• hedging against inflation.

Question 24

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under real estate, what are the forms of real estate investing?

Answer 24

Question 25

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under real estate, what are the real estate investment categories?

Answer 25

Real estate investment categories include:

• residential properties;
• commercial real estate;
• REITs;
• mortgage-backed securities, and;
• timberland and farmland.

Question 26

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under real estate, what are returns correlated with? What may contribute to these correlations?

Answer 26

Historically, real estate returns are highly correlated with global equity returns but less correlated with global bond returns. The construction method of real estate indexes may contribute to the low correlation with bond returns.

Question 27

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under real estate, what are the due diligence factors?

Answer 27

Due diligence factors for real estate include:

• global and national economic factors
• local market conditions
• interest rates, and;
• property-specific risks including regulations and abilities of managers.

Distressed properties investing and real estate development have additional risk factors to consider.

Question 28

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under commodities, what is the most common ways to invest in them? What are some other methods?

Answer 28

The most common way to invest in commodities is with derivatives.

Other methods include:

• exchange-traded funds
• equities that are directly linked to a commodity
• managed futures funds
• individual managed accounts, and;
• specialized funds in specific commodity sectors.

Question 29

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under commodities, what are the potential benefits?

Answer 29

Beyond the potential for higher returns and lower volatility benefits to a portfolio, commodity as an asset class may offer inflation protection. Commodities can offset inflation, especially if commodity prices are used to determine inflation indices.

Question 30

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under commodities, how are prices determined?

Answer 30

Spot prices for commodities are a function of supply and demand. Global economics, production costs, and storage costs, along with value to user, all factor into prices.

Question 31

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under infrastructure, how are investments classified?

Answer 31

Infrastructure investments may be classified as greenfield (assets to be built) or brownfield (existing assets).

Question 32

LOS 59. d: Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence. Under infrastructure, what are the potential benefits and risks.

Answer 32

Liquidity is low for direct investments in infrastructure because the assets are long-lived and tend to be large-scale. However, some liquid investment vehicles exist that are backed by infrastructure assets.

Question 33

LOS 59. e: Describe, calculate, and interpret management and incentive fees net-of-fees returns to hedge funds.

Answer 33

The total fee for a hedge fund consists of a management fee and an incentive fee. Other fee structures specifications include hurdle rates and high water marks. Funds of funds incur an additional level of management fees. Fee calculations for both management fees and incentive fees can differ by the schedule and method of fee determination.

Question 34

LOS 59. f: Describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure.

Answer 34

Hedge funds often invest in securities that are not actively traded and must estimate their values, and invest in securities that are illiquid relative to the size of a hedge fund’s position. Hedge funds may calculate a trading NAV that adjusts for the illiquidity of these securities.

Question 35

LOS 59. f: Describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure.

Answer 35

A private equity portfolio company may be valued using a market/comparable approach (multiple-based) approach, a discounted cash flow approach, or an asset-based approach.

Question 36

LOS 59. f: Describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure.

Answer 36

Real estate property valuation approaches include the comparable sales approach, the income approach (multiple or discounted cash flows), and the cost approach. REITs, can be valued using an income-based approach or an asset-based approach.

Question 37

LOS 59. f: Describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure.

Answer 37

A commodity futures price is approximately equal to the spot price compounded at the risk-free rate, plus storage costs, minus the convenience yield.

Question 38

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of standard deviation of returns?

Answer 38

Standard deviation of returns may be misleading as a measure of risk.

Question 39

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of the use of derivatives?

Answer 39

Use of derivatives introduces operational, financial, counterparty, and liquidity risks.

Question 40

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of measuring performance?

Answer 40

Performance for some alternative investment categories depends primarily on management experience.

Question 41

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of hedge funds and private equity funds?

Answer 41

Hedge funds and private equity funds are less transparent than traditional investments

Question 42

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of alternative investments?

Answer 42

Many alternative investments are illiquid.

Question 43

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of measuring future returns and volatility?

Answer 43

Indices of historical returns and standard deviations may not be good indicators of future returns and volatility.

Question 44

LOS 59. g: Describe risk management of alternative investments.

Risk management of alternative investments requires understanding of the unique circumstances for each category, what is the risk of correlations?

Answer 44

Correlations vary across period and are affected by events.

Question 45

LOS 59. g: Describe risk management of alternative investments. What are key items for due diligence?

Answer 45

Key items for due diligence include:

• organization,
• portfolio management,
• operations and controls,
• risk management,
• legal review, and;
• fund terms.