Alternative Investments Flashcards
25.b: Explain and justify the major due diligence checkpoints involved in
selecting active managers of alternative investments.
Assess the market opportunity offered.
Assess the investment process. What is the manager’s competitive edge over others in that market? How does the manager’s process identify potential opportunities?
Assess the organization
Assess the people
Assess the terms and structure of the investment
Assess the service providers
Review documents.
25.c: Explain distinctive issues that alternative investments raise for
investment advisers of private wealth clients.
1) Taxes
2) Communication
3) Comitment
4) COncentratiion
5) Decision risk - This could be defined as the risk of emotionally abandoning a strategy right at the point of maximum loss
25.d: Distinguish among the principal classes of alternative investments,
including real estate, private equity, commodity investments, hedge funds,
managed futures, buyout funds, infrastructure funds, and distressed securities.
Equity REITS own and operate properties while mortgage
REITS hold mortgages on real estate.
Commingled real estate funds (CREFs), which are pooled investments in real estate that are professionally managed and privately held.
Infrastrure funds.
advantages: - low correlation with stocks and bonds (providing a portfolio diversification benefit), low volatility of return, and often an inflation hedge.
Real estate may also offer tax advantages and the potential to leverage return.
Disadvantes - High informational cost, can't divide , tranactional cost . Real estate as an asset class and each individual real estate asset can have a large idiosyncratic risk component.
Private equity -
Venture Capital funds / Buy out funds
buyout funds are middle-market buyout funds and mega-cap
buyout funds.
) restructuring company
operations and management, 2) buying companies for less than intrinsic value, and
3) creating value by adding leverage or restructuring existing debt of the company.
Comodity - low correlation with stocks and bonds and business-cycle sensitivity, and most have a positive correlation with inflation.
25.e: Discuss the construction and interpretation of benchmarks and the
problem of benchmark bias in alternative investment groups.
National Council of Real Estate Investment Fiduciaries
(NCREIF) Property Index as its principal benchmark for direct investments.
Value weight - published quarterly - so volatility is downward biased.
National Association of Real Estate Investment Trusts (NAREIT) Index is for Indirect investment
The NAREIT Index is cap-weighted and includes all REITs traded on the NYSE or AMEX. the monthly NAREIT Index is “live and represent current value
The unsmoothed data raises the standard
deviation and reduces the Sharpe ratio of real estate,
Hedge Fund Benchmarks - Selection Criteria - AUM, duration , restriction imposed
Style classification -how they classify the fund
weighing schemes - equally weighted or by AUM
rebalancing rules - for equally wieghted - can vary monthly or yearly .investability
issuse with hedge funds. Relevance bias, Popularity bais , survivorship bias, stale price bias, back fill bias,
25.f: Evaluate the return enhancement and/or risk diversification effects of adding an alternative investment to a reference portfolio (for example, a portfolio invested solely in common equity and bonds).
each investment has a large idiosyncratic (unsystematic) risk component
Commodities chiefly offer diversification to a portfolio of stocks and bonds. Correlations
of commodity indices with stocks and bonds have been low and even slightly negative. With the exception of the agricultural subgroups, commodity indices have a strong
positive correlation with inflation.
25.h: Discuss the major issuers and suppliers of venture capital, the
stages through which private companies pass (seed stage through exit), the
characteristic sources of financing at each stage, and the purpose of such
financing.
Venture capatalist, corprate venturing, angel investors.
Early stage, startfunds, First stage of funding,
expansion stage,
Second stage of funding,
thrid stage of funding,
Mezzanine or bridge financing and exit stage.
25.i: Compare venture capital funds and buyout funds.
A higher level of leverage.
Earlier and steadier cash flows.
Less error in the measurement of returns as more of the return is from cash flow
return.
Less frequent losses.
Less upside potential.
25.j: Discuss the use of convertible preferred stock in direct venture capital investment.
25.k: Explain the typical structure of a private equity fund, including the
compensation to the fund’s sponsor (general partner) and typical timelines.
25.l: Discuss issues that must be addressed in formulating a private equity
investment strategy.
The incentive fee is also called the carried interest. -often after a minimum required return or hurdle rate has been paid
on the cash from the outside investors.
giving “capital calls” over the first five years (typically).
This is referred to as the commitment period.
Low liquidity: the portfolio allocation to this class should typically be 5% or less
Diversification through a number of positions: because commitments are usually large, .
Diversified, commingled funds exist for
smaller investors, but these funds have additional fees.
Diversification strategy: knowing the unique aspects of a proposed private equity investment as they relate to the overall portfolio.
Plans for meeting capital calls: committed funds are called as needed, and the investor needs to be prepared to meet the calls.
25.m: Compare indirect and direct commodity investment.
25.n: Explain the three components of return for a commodity futures
contract and the effect that an upward-or downward-sloping term structure of
futures prices will have on roll yield.
Indirect investment may be more convenient, but it may provide very little exposure to the commodity, especially if the company is hedging the risk itself.
total return = spot return + collateral return + roll return
Spot return or price return of the underlying commodity.
Collateral return is the periodic risk-free return.
Roll yield or return is the change in the futures contract price for the time period minus the change in the spot price of the commodity for the period.
25.o: Describe the principal roles suggested for commodities in a
portfolio and explain why some commodity classes may provide a better hedge
against inflation than others.
Two factors affect whether a commodity is a good hedge against
unexpected inflation: storability and demand relative to economic activity.
Non-storable commodities like agricultural commodities (e.g., livestock, wheat, corn) have shown values that are negatively (positively) affected by unexpected increases
(decreases) in inflation.
25.p: Identify and explain the style classification of a hedge fund, given a
description of its investment strategy.
Relative value strategies attempt to exploit price discrepancies. This category combines the equity market neutral, the convertible arbitrage, and fixed-income
arbitrage strategies mentioned previously. As the name implies, this strategy compares the relative values of assets and attempts to capitalize, through various
long and short strategies, on the relative mispricing.
2. Event-driven strategies invest with a short-term focus on an event like a merger
(merger arbitrage) or the turnaround of a distressed company (distressed securities).
3. Equity hedge entails taking long and short equity positions with varying overall net
long or short positions and can include leverage.
4. Global asset allocators take long and short positions in a variety of both financial and
non-financial assets.
5. Short selling takes short-only positions in the expectation of a decline in value
25.r: Describe the purpose and characteristics of fund-of-funds hedge
funds.
FOP returns have been more highly correlated with equity markets than those of
individual hedge funds
An FOP can, however, suffer from style drift
An FOP may be a better indicator of aggregate hedge fund performance than the typical
hedge fund index because it suffers from less survivorship and backfill bias.
The point is to achieve diversification, but the extra layer of management means
an extra layer of fees.
25.v: Explain event risk, market liquidity risk, market risk, and “J-factor
risk” in relation to investing in distressed securities.
Event risk refers to the fact that the return on a particular investment within this class typically depends on an event for the particular company. Because these events are usually unrelated to the economy, they can provide diversification benefits.
Market liquidity risk refers to low liquidity and the fact that there can be cyclical supply and demand for these investments.
Market risk from macroeconomic changes is usually less important than the first two
types mentioned.
]-factor risk refers to the role that courts and judges can play in the return, and this
involves an unpredictable human element. By anticipating the bankruptcy court
judge’s rulings (the ]-factor), the distressed security investor knows whether to
purchase the distressed company’s debt or equity.
- U Describe strategies and risks associated with investing in distressed
securities.
long-only value
investing, distressed debt arbitrage, and private equity.
High-yield investing
is buying publicly traded, below-investment grade debt. Orphan equities investing is the purchase of the equities of firms emerging from reorganization.
The reason these present a market opportunity is that some investors cannot participate in this market and many
do not wish to do the necessary due diligence.
Distressed debt arbitrage is the purchasing of a company’s distressed debt while short
selling the company’s equity.
Private equity is an “active” approach where the investor acquires positions in the
distressed company
Vulture funds, which specialize in purchasing
undervalued distressed securities, engage in this type of strategy.
