Alternative Investments Flashcards
Discuss how hedge fund strategies may be classified.
Hedge fund strategies are classified based on the instruments they invest in, the philosophy followed, and the kinds of risk exposures taken.
This reading classifies hedge fund strategies into the following six categories:
1. Equity related.
2. Event driven.
3. Relative value.
4. Opportunistic.
5. Specialist.
6. Multi-manager.
Discuss investment characteristics, strategy implementation, and role in a portfolio of equity-related hedge fund strategies.
Long/short equity: This strategy generates alpha via careful stock picking. L/S funds are typically liquid, and generally net long. Equity L/S managers aspire to the returns of a long-only approach but with lower standard deviations. The more market-neutral the approach, the more leverage is likely to be applied.
Dedicated short-selling and short-biased strategies: These two strategies have a negative correlation to traditional assets and modest return goals. The focus is on stock picking using minimal leverage. Dedicated short strategies are generally 60%–120% short at all times, while short-biased strategies are typically 30%–60% net short with some long exposure. Short-biased managers moderate short beta with some long exposure (and cash).
Equity market-neutral (EMN): These strategies attempt to profit from short-term mispricing between securities. Beta risk is minimal, making EMN strategies attractive in periods of market weakness. Most managers are quantitative (vs. discretionary). High leverage is usually used.
Discuss investment characteristics, strategy implementation, and role in a portfolio of event-driven hedge fund strategies.
Merger arbitrage: This strategy attempts to profit by taking positions on a corporate takeover. Merger arbitrage returns are usually insurance-like with a high Sharpe ratio. However, left-tail risk is present. Negative returns can occur if a merger deal unexpectedly fails. Some leverage is usually applied to generate meaningful returns. It is a relatively liquid strategy.
Distressed securities: These strategies focus on firms in bankruptcy or facing other financial stress and seek out mispriced securities. Distressed securities strategies are usually long biased with high illiquidity and moderate or low leverage. Returns tend to be high compared to other event-driven strategies.
Discuss investment characteristics, strategy implementation, and role in a portfolio of relative value hedge fund strategies.
Fixed-income arbitrage: This strategy attempts to profit from the mispricing of bonds. Sub-strategies include yield curve trades and carry trades. Fixed-income arbitrage usually uses high leverage.
Convertible arbitrage: These strategies attempt to extract “underpriced” implied volatility from long convertible bonds. Convertible arbitrage works best when there is high convertible issuance, adequate market liquidity, and moderate volatility. Liquidity issues may arise from convertibles being somewhat illiquid. Convertible arbitrage managers generally run about 300% long versus 200% short.
Discuss investment characteristics, strategy implementation, and role in a portfolio of opportunistic hedge fund strategies.
Opportunistic strategies tend to be highly liquid and use high leverage.
Global macro: These strategies use discretionary approaches and a range of financial instruments to exploit trends in global financial markets. Global macro strategies offer diversification during periods of stress but with mixed outcomes.
Managed futures: In these strategies, a portfolio of futures contracts is actively managed using systematic approaches to provide portfolio and market diversification. Managed futures strategies often exhibit right-tail skew during market turmoil.
Discuss investment characteristics, strategy implementation, and role in a portfolio of specialist hedge fund strategies.
Specialist hedge fund strategies operate in market niches in order to generate uncorrelated returns. Success with these strategies usually requires specialized knowledge.
Volatility traders: These strategies seek to profit from changes in the term structure of volatility. OTC options can be used to create bull spreads, bear spreads, straddles, and calendar spreads. Alternatively, other instruments including VIX futures, volatility swaps, and variance swaps can be used.
Life settlements: In these strategies, pools of life insurance contracts are purchased, and the hedge fund becomes the beneficiary. The hedge fund manager looks for policies with low surrender value, low ongoing premium payments, and high probability that the insured person will die soon.
Discuss investment characteristics, strategy implementation, and role in a portfolio of multi-manager hedge fund strategies.
Multi-manager hedge fund strategies use strategy diversification in an attempt to produce low-volatility, steady returns.
Funds-of-funds: This strategy involves a hedge fund that invests in other hedge funds. Funds-of-funds can offer a very broad strategy mix but can suffer from a lack of transparency and slower tactical execution, and can also expose the FoF investor to netting risk.
Multi-strategy funds: In this hedge fund strategy, a single hedge fund pursues a combination of strategies all under one roof. Compared to funds-of-funds, multi-strategy funds offer a better fee structure and faster tactical asset allocation, though operational risks are less diversified.
Describe how factor models may be used to understand hedge fund risk exposures.
Conditional linear factor models can be useful for analyzing hedge fund strategies in terms of their risk factor exposures. The curriculum makes use of a specific four-factor model (incorporating equity risk, currency risk, volatility risk, and credit risk factors) to quantify a strategy’s exposures.
Evaluate the impact of an allocation to a hedge fund strategy in a traditional investment portfolio.
Hedge funds generally bring diversification to traditional stock/bond portfolios, and enhance risk-adjusted returns. The addition of a 20% hedge fund allocation to a traditional 60% stock/40% bond portfolio generally decreases the portfolio’s total standard deviation, increases the Sharpe and Sortino ratios, and decreases maximum drawdown.
Explain the roles that alternative investments play in multi-asset portfolios.
Allocating portfolio assets to alternative investments can improve the risk-adjusted return of a portfolio that includes only traditional asset classes. Private equity and private credit may be viewed primarily as return-enhancing portfolio investments. Real assets may be viewed as risk-reducing investments. Hedge funds may serve either function in a portfolio, depending on the strategies they pursue.
Compare alternative investments and bonds as risk mitigators in relation to a long equity position.
Whether bonds or alternative investments are better risk mitigators for an equity portfolio depends on the investor’s time horizon. Over short horizons, return volatility is the predominant risk, and bond returns have a lower correlation with equity returns than do alternative investment returns. Over long horizons, the main risk is failing to achieve the target return, so alternative investments may be more suitable than bonds because of their higher expected returns.
Compare traditional and risk-based approaches to defining the investment opportunity set, including alternative investments.
Traditional approaches to defining the investment opportunity set may be based on asset classes’ liquidity or expected performance in different scenarios for economic growth and inflation.
A liquidity-based approach would distinguish among alternative investment classes that are publicly traded, such as REITs and commodity futures, and those that are not publicly traded, such as private equity.
An approach based on expected performance would distinguish alternative investment classes that are expected to outperform in a high-growth economy, such as private equity, from those that would be expected to provide an inflation hedge, such as indexed bonds or real assets.
A risk factor based approach to defining asset classes involves statistically estimating their sensitivities to risk factors. Its advantages compared to traditional approaches are that it can identify sources of risk that are common to different asset classes (such as public and private equity) and allow a manager to analyze multiple dimensions of portfolio risk. Its limitations are that it can be difficult to communicate to decision makers and to implement, and that its results may be sensitive to the historical period used in the analysis.
Discuss investment considerations that are important in allocating to different types of alternative investments.
In addition to risk, return, and correlation, important considerations for alternative investments include investment vehicles, liquidity, expenses and fees, taxes, and the need to obtain special understanding of the asset class.
Alternative investment funds are typically structured as limited partnerships, with the manager as general partner and investors as limited partners. Investors that are not large enough to invest directly in limited partnerships often invest in funds-of-funds to gain exposure to alternative investments.
Liquidity concerns include lock-up periods, redemption restrictions, the opportunity cost of committed capital, and the practice of “side pocketing” to exempt some assets from a hedge fund’s redemption terms.
Alternative investment funds charge management fees and incentive fees. Management fees are based on committed capital rather than called capital. Investors must ensure that a fund’s activities and distributions are consistent with their tax situations.
When deciding whether to invest through funds-of-funds or develop an in-house program, investors should consider the expense of developing and maintaining a program, their needs for customized solutions and close control, and whether they intend to make co-investments with general partners.
Discuss suitability considerations in allocating to alternative investments.
Alternative investments are suitable for large investors with long time horizons, the specialized knowledge to succeed in this asset class, strong governance frameworks, comfort with a lack of transparency, and a belief that active management can create value.
Discuss approaches to asset allocation to alternative investments.
Asset allocation approaches such as Monte Carlo simulation, mean–variance optimization, and risk factor based optimization can be extended to include alternative investments. However, investors must take care to adjust the data for this asset class for smoothed returns that underestimate risk, and to include constraints in their asset allocation models. Otherwise, these techniques are likely to over-allocate to alternative investments.
