Alternative Investments (8%) Flashcards
1
Q
Identify which of the following choices is most likely an alternative investment:
A.An investment in a hedge fund focused on traditional assets
B.Shares in a manufacturing firm traded on the Bursa Malaysia exchange
C.A euro foreign exchange future purchased on the Chicago Mercantile exchange
A
The correct answer is A. An investment in a hedge fund, even one that purchases traditional exchange-traded assets, is considered an alternative investment.
2
Q
Alternative investments:
definition
A
investments other than ownership of traditional asset classes (public equity and fixed-income instruments and cash) and include private capital, real assets, and hedge funds.
3
Q
Alternative investments:
purpose
A
Investors often consider alternative investments in pursuit of greater portfolio diversification and/or increased expected returns.
In doing so, they usually face
4
Q
Alternative investments:
downside
A
longer investment periods
reduced liquidity, and
less efficient markets than for more traditional assets.
5
Q
Private Capital
A
a broad term for funding provided to companies that is sourced from neither the public equity nor the public debt markets.
Capital that is provided in the form of equity investments is called private equity, whereas capital that is provided as a loan or other form of debt is called private debt.
6
Q
Private Equity:
Target Firms
A
private equity is used in the mature life cycle stage or for firms in decline, with leveraged buyouts being a key approach.
7
Q
Venture Capital:
Definition
A
a specialized form of private equity whereby ownership capital is used for non-public companies in the early life cycle or startup phase, where often an idea or business plan exists with a limited operation or customer base.
8
Q
private debt:
venture debt
A
venture debt is extended to early-stage firms with little or no cash flow
9
Q
private debt:
distressed debt
A
involves public or private debt of corporate issuers believed to be close to or in bankruptcy that could benefit from investors with capital restructuring skills.
10
Q
real assets
A
Generally, these are tangible physical assets, such as real estate, infrastructure, and natural resources, but they also include such intangibles as patents, intellectual property, and goodwill. Real assets generate current or expected future cash flows and/or are considered a store of value.
11
Q
real estate
A
Includes borrowed or ownership capital in buildings or land. Developed land includes commercial and industrial real estate, residential real estate, and infrastructure.
12
Q
Infrastructure
A
A type of real asset that is intended for public use and provides essential services. These assets are typically long-lived fixed assets, such as bridges and toll roads.
13
Q
public–private partnership (PPP)
A
An agreement between the public sector and the private sector to finance, build, and operate public infrastructure, such as hospitals and toll roads.
14
Q
concession agreement
A
A legal agreement in infrastructure investing that governs the investor’s obligations to construct and maintain infrastructure as well as the exclusive right to operate and earn fees for a pre-determined period.
15
Q
Natural resources
A
These include commodities (hard and soft), agricultural land (farmland), and timberland.
16
Q
commodities
A
product or service from a firm that is indistinguishable from products or services of competing firms, usually conforming to a common standard or grade imposed by convention or regulation.
17
Q
digital assets
A
The umbrella term covering assets that can be created, stored, and transmitted electronically and have associated ownership or use rights. Digital assets include a variety of assets, such as cryptocurrencies, tokens (security and utility), and digital collectables.
18
Q
hedge funds
A
Private investment vehicles that may invest in public equities or publicly traded fixed-income assets, private capital, and/or real assets, but they are distinguished by their investment approach rather than by the investments themselves.
19
Q
Fund of Funds
A
Funds that hold a portfolio of hedge funds; also called funds of hedge funds.
20
Q
Three methods for accessing alternative investments
A
Investors can access alternative investments through three main methods:
Fund Investment
Co-Investment
Direct Investment
21
Q
Fund Investment:
Definition
A
Investors contribute capital to a fund, which identifies, selects, and manages investments.
22
Q
Fund Investment:
Structure
A
The fund charges a management fee and a performance fee for superior results.
23
Q
Fund Investment:
Advantages
A
Suitable for investors with limited resources or experience. Provides exposure to a diversified portfolio managed by professionals.
24
Q
Fund Investment:
Disadvantages
A
Limited control over specific investments and potentially higher fees.
25
Coinvestment:
Definition
Investors invest alongside a fund in specific deals, gaining direct exposure to the assets.
26
Coinvestment:
Advantages
Lower fees compared to fund-only investments and greater control over investment decisions. Investors can expand their knowledge and skills.
27
Coinvestment:
Disadvantages
Requires more involvement and oversight from the investor.
28
Direct Investment:
Definition
Investors directly invest in companies or projects without using an intermediary fund.
29
Direct Investment:
Advantages
Maximum flexibility and control over investment choices, financing methods, and timing. Suitable for sophisticated investors with specialized knowledge.
30
Direct Investment:
Disadvantages
Requires significant resources, expertise, and oversight capabilities. Typically undertaken by large institutions like sovereign wealth funds or pension funds.
31
Alternate Investments:
Ownership Structures
Typically involve partnerships, especially limited partnerships, with at least one general partner (GP) managing the fund and outside investors as limited partners (LPs). LPs have limited liability and are passive investors, while GPs have unlimited liability and manage the fund’s operations.
32
Alternate Investments:
Compensation Structures
Use a combination of management fees and performance fees.
33
limited partnership agreement (LPA):
Definition
A legal document that outlines the rules of the partnership and establishes the framework that ultimately guides the fund’s operations throughout its life.
34
Limited partnership agreement (LPA):
Key Feature
Key features of an LPA include the distribution of profits and losses (covered in detail below); manager roles and responsibilities, such as investment criteria and restrictions; and terms governing transfers, withdrawals, and dissolution of the agreement.
35
Limited partnership agreement (LPA):
Side Letter
A side agreement created between the GP and specific LPs. These agreements exist outside the LPA. These agreements provide additional terms and conditions related to the investment agreement.
36
master limited partnership (MLP):
definition
Has similar features to limited partnerships but is usually a more liquid investment that is often publicly traded
37
master limited partnership (MLP):
uses
Real estate or natural resource fund
38
performance fee
Fee paid to the general partner from the limited partner(s) based on realized net profits.
39
carried interest
A performance fee (also referred to as an incentive fee, or carry) that is applied based on excess returns above a hurdle rate.
40
committed capital
The amount that the limited partners have agreed to provide to the private equity fund.
41
PE management fee
management fee is typically based on committed capital, not invested capital; the committed-capital basis for management fees is an important distinction from hedge funds, whose management fees are based on assets under management (AUM).
Using committed capital as the basis for management fee calculations reduces the incentive for GPs to deploy the committed capital as quickly as possible (in order to increase near-term management fees). This allows the GPs to be selective about deploying capital into investment opportunities.
42
hurdle rate
Also called “preferred return.” The minimum rate of return on investment that a fund must reach before a GP receives carried interest.
43
hard hurdle rate
Hurdle rate where the manager earns fees on annual returns in excess of the hurdle rate
44
soft hurdle rate
Hurdle rate where the fee is calculated on the entire return when the hurdle is exceeded. With a soft hurdle, GPs are able to catch up performance fees once the hurdle threshold is exceeded.
With a soft hurdle, GPs are able to catch up performance fees once the hurdle threshold is exceeded.
45
catch-up clause
The acceleration of performance fees once a fund exceeds the soft hurdle rate.
A clause in an agreement that favors the GP. For a GP who earns a 20% performance fee, a catch-up clause allows the GP to receive 100% of the distributions above the hurdle rate until she receives 20% of the profits generated, and then every excess dollar is split 80/20 between the LPs and GP.
46
high-water mark:
definition
The highest value, net of fees, that a fund has reached in history. It reflects the highest cumulative return used to calculate an incentive fee.
47
High-water mark:
penalization
If the fund’s value subsequently declines below the high-water mark, the hedge fund manager may not charge performance fees until the fund value exceeds the previous high-water mark. The use of high-water marks seeks to reward managers for sustained performance and protect LPs from paying twice for the same returns.
48
clawback provision
A requirement that the general partner return any funds distributed as incentive fees until the limited partners have received their initial investment and a percentage of the total profit.
49
waterfall types:
deal-by-deal
Deal-by-deal waterfalls are more advantageous to the GP because performance fees are collected on a per-deal basis, allowing the GP to get paid before LPs receive both their initial investment and their preferred rate of return (i.e., the hurdle rate) on the entire fund.
50
waterfall types:
whole-of-fund
In whole-of-fund waterfalls, all distributions go to the LPs as deals are exited and the GP does not participate in any profits until the LPs receive their initial investment and the hurdle rate has been met. In contrast to deal-by-deal waterfalls, whole-of-fund waterfalls occur at the aggregate fund level and are more advantageous to the LPs
51
Identify the following statement as true or false: Limited partners (LPs) are involved in the management of the alternative investment fund in which they invest; they assist the general partner (GP) in the operations and decisions of the fund.
True
False
False. LPs play passive roles and are not involved in the management of the fund (although co-investment rights allow LPs to make additional direct investments in the portfolio companies); the operations and decisions of the fund are controlled solely by the GP.
52
Calculate the general partner’s performance fee earned based on the following terms:
rGP=max[0, p(r – rh)]
rGP = max[0, 18%(20% – 10%)]
rGP = 1.8%.
53
In which part of the investment life cycle of a private equity investment should investors generally expect a positive cash flow?
A. Capital commitment
B. Capital deployment
C. Capital distribution
C is correct. In the initial capital commitment phase, fees and expenses are immediately incurred prior to capital deployment, and assets may generate little or no income during this first phase. In the capital deployment phase, cash outflows typically exceed inflows as funds are deployed. Only in the capital distribution phase can excess income be generated from the invested properties and substantial capital gains be realized upon the sale of assets.
54
preferred measure for alternative investment returns
Internal rate of return (IRR)
55
Why is IRR preferred for performance measurement for alternative investments?
A. IRR is commonly used for other asset classes.
B.IRR is easy and intuitive to calculate.
C.IRR takes into account the timing of cash flows in long-lived alternative investments.
C is correct. IRR is seldom used to measure investment performance of other asset classes with publicly quoted market prices. Although IRR is complicated to calculate and involves assumptions on opportunity costs and reinvestment rates, it is the best metric to evaluate long-lived alternative investments because it takes into account the unique timing of cash flows in the investment life cycle of alternative investments.
56
Which of the following statements regarding hedge fund fee structure is correct?
A.The periodic returns of all investors in the same fund must be identical.
B.Hedge funds usually charge a performance fee based on a percentage of periodic return above a certain threshold.
C.The management and performance fee rates are always the same for all investors in the same fund.
B is correct. A hedge fund usually charges both a flat management fee and an additional performance fee based on a percentage of periodic fund returns. Periodic performance results may vary based on which investor has invested and when the investor invested into the fund. Besides, a particular investor may face significantly lower incentive fees if she invests more capital in a fund at an earlier phase or is willing to accept greater restrictions on redemption
57
A $100 million hedge fund charges all its investors a 2% management fee and a 20% performance fee if the periodic return, net of management fee, exceeds a 5% hard hurdle rate. All fees are deducted based on the end-of-year value. If the fund makes a gross return (before fees) of 8% for the year, what is the investor’s return, net of fees, closest to (ignoring any high-water mark provisions)?
A. 4.67%
B. 5.67%
C. 5.84%
B is correct. If the hedge fund makes 8% gross return for the year, its net asset value has grown to $108 million before any fees are deducted.
Management fee = $108 × 2% = $2.16 million.
Performance fee = [($108 – $2.16) – ($100 × $1.05%)] × 20% = $0.168 million.
Net asset value after fee deduction = $108 – $2.16 – $0.168 = $105.672 million.
Net investor return = ($105.672 – $100)/$100 ≈ 5.67%.
58
Alternative Investment Phases:
Capital Commitment
Alternative managers identify and select appropriate investments with either an immediate or a delayed commitment of capital (known as a capital call) that may be in an early-stage company in the case of venture capital, a more mature firm for private equity, or one or more properties in the case of real estate. Returns are usually negative over this phase because fees and expenses are immediately incurred prior to capital deployment and assets may generate little or no income during this first phase.
59
Alternative Investment Phases:
Capital deployment
Over this second phase, alternative managers deploy funds to engage in construction or make property improvements in the case of real estate or infrastructure, incur expenses in the turnaround phase of a mature company in the case of private equity, or initiate operations for a startup using venture capital. Cash outflows typically exceed inflows, with management fees further reducing returns.
60
Alternative Investment Phases:
Capital distribution
When the turnaround strategy, startup phase, or property improvements are completed and if the investment is successful, the underlying assets appreciate in price and/or generate income in excess of costs, causing fund returns to accelerate.
The fund may realize substantial capital gains from liquidating or exiting its investments, which may involve an initial public offering (IPO) for venture capital or the sale of properties in the case of real estate.
61
J-Curve Effect
Represents the initial negative return in the capital commitment phase followed by an acceleration of returns through the capital deployment phase.
62
multiple of invested capital (MOIC)
A simplified calculation that measures the total value of all distributions and residual asset values relative to an initial total investment; also known as a money multiple.
63
Himitsu, a private equity firm, makes an initial investment of JPY3.8 billion into ZZZ company in Year 0. Eight years later, it sells its stake in ZZZ for JPY8.5 billion. Additional capital investments were made in Year 2 and in Year 3 for JPY1.2 billion and JPY200 million, respectively.
Calculate the MOIC.
MOIC = 8.5/(3.8 + 1.2 + 0.2) = 1.63
64
primer brokers
A broker that provides services that commonly include custody, administration, lending, short borrowing, and trading.
65
margin financing
broker lends shares, bonds, or derivatives and the hedge fund (or investment manager) deposits cash or other collateral into a margin account at the prime broker based on certain fractions of the investment positions.
66
Which of the following is not a factor that makes comparison of performance between alternative investments and public securities difficult?
A. Alternative investments charge higher fees.
B. The use of leverage in alternative investments magnifies their risk and return measures.
C.The fair value of portfolio positions in alternative investments may not be readily available.
A is correct. Although an alternative investment may charge a higher fee, it is not the absolute fee level but the complexity of the fee arrangement that makes alternative investment appraisal unique compared to other common asset classes.
Alternative investments often involve the use the of explicit leverage, which has the effect of magnified gains and losses. Alternative assets are often characterized by illiquidity with unobservable market prices, making performance appraisal over time and periodic comparison with common asset classes challenging.
67
Describe the J-curve effect in alternative investments.
The J-curve effect in alternative investments describes the initial negative return in the capital commitment phase followed by an acceleration of returns through the capital deployment phase. Returns often level off as capital is distributed to investors, investments are sold, and the fund is closed.
68
A private equity closes a fund with a capital commitment of €750 million. It has a capital call of €500 million initially and another €250 million at the end of Year 1. The management fee is 2% per annum. At the end of Year 5, a total of €1.0 billion is distributed to its investors, and the fund is left with €500 million in asset value. The multiple of invested capital (MOIC) after five years is closest to:
A) 1.3×
B) 2.0×
C) 2.2×
C is Correct.
Total paid-in capital = 500 + 250 = 750.
Total management fee for 5 years = 750 × 0.02 × 5 = 75.
Total invested capital = 750 – 75 = 675.
MOIC = (1,000 + 500)/675 ≈ 2.2×.
69
70
redemption fee
A fee charged to discourage redemptions and to offset the transaction costs for remaining investors in the fund.
71
notice period
The length of time (typically 30–90 days) in advance that investors may be required to notify a fund of their intent to redeem some or all of their investment. This allows a fund manager to liquidate a position in an orderly fashion without magnifying losses.
72
lockup period
The minimum holding period before investors are allowed to make withdrawals or redeem shares from a fund. Its purpose is to allow the hedge fund manager the required time to implement and potentially realize a strategy’s expected results.
73
gate
A provision that when implemented limits or restricts redemptions for a period of time.
74
Custom Fee Arrangements:
Fees based on liquidity terms and asset size
Limited partnerships may charge different rates depending on the liquidity terms that an investor is willing to accept (longer lockups resulting in lower fees), and managers may discount their fees for larger investors or for placement agents who introduced these investors. Different investors in the same fund may face different fee structures.
75
Founders shares
A way to entice early participation in startup funds whereby managers offer incentives that entitle investors to a lower fee structure and/or other favorable terms.
76
Either/or fees
A custom fee arrangement whereby major investors are offered a structure where managers agree to charge either a lower management fee or a higher incentive fee, whichever is greater.
77
survivorship bias
The exclusion of failed funds from a given benchmark is a form of selection bias that can lead investors to overly optimistic return expectations
78
backfill bias
The subsequent inclusion or “backfilling” of prior performance data on a selective basis serves to increase average reported returns
79
Hedge Fund Indexes
A common problem with hedge fund indexes is the upward bias due to:
A.backfill bias only.
B.survivorship bias only.
C.both backfill and survivorship bias.
C is correct. Both backfill bias and survivorship bias are common in hedge fund indexes.
80
At the conclusion of a public company’s leveraged buyout, the amount of its market-traded stock is substantially:
A. reduced.
B. increased.
C. unaffected.
A is correct. After the transaction, the target company becomes or remains a privately owned company.
Leveraged buyouts are sometimes called “going-private” transactions because after the acquisition of a publicly traded company, the target company’s equity is substantially no longer publicly traded.
81
Which of the following financing tools would most likely be used at the later stage of venture capital investment?
A. Common stock
B. Preferred stock
C. Convertible debt
B is correct. Preferred stock can be deployed as late into a company’s maturity as later-stage venture capital, when preferred stock can offer more protection to venture investors as a company transitions toward an IPO. A and C are incorrect because these instruments are more typically used in the earlier pre-seed and seed stages.
82
Which of the following transaction features is associated with mezzanine debt?
A. Warrants
B. Lines of credit
C. Fixed payment schedules
A is correct. Mezzanine debt often comes with additional features, such as warrants or conversion rights.
83
In using private debt for a syndicated leveraged mortgage portfolio, the financial ratio of loan to value (LTV) is important at:
A. origination and to the real estate fund sponsor.
B.syndication and to the private debt fund lender.
C.both transaction phases and to each of the parties.
C is correct. LTV plays a significant role in both legs of this transaction.
84
Vintage diversification is an advisable policy for implementation by private capital:
A. funds.
B. investors.
C. users, such as company managers.
B is correct. The vintage year, the time when fund deployment begins, is important for comparing PE and VC investments with other funds in the same year. Because of changing business and valuation environments, funds of a certain vintage have a relative advantage based on their start-up timing. That is why investors are encouraged to pursue vintage diversification by investing in multiple vintage years.
85
The potential diversification benefits from private capital investment are most likely related to its:
A. wide range of exit strategies.
B. various types of fee structures.
C. lower correlation with public asset returns.
C. lower correlation with public asset returns.
86
private capital
Funding provided to companies that is not sourced from the public markets.
87
private equity
Equity investment capital raised from sources other than public markets and traditional institutions.
88
private debt
Capital extended to companies through a loan or other form of debt.
89
leveraged buyout
Transactions whereby the target company's management team converts the target to a privately held company by using heavy borrowing to finance the purchase of the target company's outstanding shares.
90
management buyout
A type of leveraged buyout where the current management team participates in the acquisition.
91
management buy-in
A type of leveraged buyout where the current management team is replaced with the acquiring team involved in managing the company.
92
Private Equity:
Types of Investments
1. Leveraged Buyout
2. Venture Capital
3. Growth Capital
93
Growth Capital
Providing capital to more mature companies for expansion or restructuring, often without taking a controlling interest.
94
Private Equity:
Exit Strategies:
Trade Sale
Selling the company or a part of it to a strategic buyer.
95
Private Equity:
Exit Strategies:
Public Listing
IPO, direct listing, or SPAC
96
Private Equity:
Exit Strategies:
Recapitalization
Increasing leverage and paying a dividend without exiting.
97
Private Equity:
Exit Strategies:
Secondary Sale
Selling the company to another private equity firm.
98
Private Equity:
Exit Strategies:
Write-off/Liquidation
Revising the value downward or liquidating the company if the investment loses value.
99
True or False:
Both public and private equity represent direct ownership and control of the corporation. Additionally, all owners have a direct and proportional claim to residual cash flow rights in the form of dividends.
True
100
Describe a funding situation to which a PIPE transaction is well suited
A PIPE transaction is well suited for a company needing to quickly raise capital with fewer disclosures and lower transaction costs than traditional public offerings. This is often used in situations like work-out or rescue scenarios where the company faces immediate financial needs, such as during the early stages of the COVID-19 pandemic when travel companies like Expedia needed rapid capital infusion.
101
Mezzanine-stage financing
Mezzanine venture capital that prepares a company to go public as it continues to expand capacity and enhance its growth trajectory. It represents the bridge financing needed to fund a private firm until it can execute an IPO or be sold.
102
PIPE (private investment in public equity)
a private offering to select investors with fewer disclosures and lower transaction costs that allows the issuer to raise capital more quickly and cost effectively than with other means that may be more regulated, expensive, and lengthy. In a traditional PIPE transaction, either newly issued common stock or shares sold by existing stockholders—or a combination of both—in an already-publicly traded company are made available to certain investors. These investors, typically investment firms, mutual funds, or other institutional investors, enter into a definitive purchase agreement with the issuer and commit to purchase securities at a fixed price.
103
Pre-seed capital, or angel investing
capital provided at the idea stage. Funds may be used to develop a business plan and to assess market potential. The amount of financing here is typically small and sourced from individuals, often friends and family, rather than by VC funds.
104
Seed-stage financing, or seed capital
generally supports product development and marketing efforts, including market research. This is the first stage at which VC funds usually invest.
105
Early-stage financing
start-up stage financing, goes to companies moving toward operation but prior to commercial production or sales, in both of which early-stage financing may be injected to initiate.
106
Later-stage financing
comes after commercial production and sales have begun but before an IPO. Funds may be used to support initial growth, a major expansion (such as a physical plant upgrade), product improvements, or a major marketing campaign.
107
Private Debt: Direct Lending
Loans provided directly to operating companies by private debt firms or funds.
108
Private Debt: Mezzanine Loans
Subordinated to senior debt but senior to equity, often used in LBOs, recapitalizations, and acquisitions. It offers higher returns due to higher risk and may include equity participation options.
109
Private Debt: Venture Debt
Provides funding to start-ups or early-stage companies with little or negative cash flow, often without diluting shareholder ownership.
venture debt may carry additional features that compensate the investor/lender for the increased risk of default or for the start-up and early-stage companies that lack substantial assets for debt collateral.
110
Private Debt: Distressed Debt
Involves buying debt of companies in financial distress, with the goal of restructuring and reviving them.
111
Private Debt: Unitranche Debt
Unitranche debt combines different tranches of secured and unsecured debt into a single loan with a single, blended interest rate. The interest rate typically falls between the rates demanded on secured and unsecured debt, providing a middle ground in terms of cost.
112
leveraged loan
Where private debt investor firms borrow money to make a direct loan to a borrower.
113
Factors Making
Performance/Risk Comparisons with Public Debt and Equity Inappropriate:
Phase of Life Cycle
The performance of private capital investments greatly depends on the specific phase of a company’s life cycle. For example, investing in a start-up carries greater risk than investing in a well-established firm.
114
Factors Making
Performance/Risk Comparisons with Public Debt and Equity Inappropriate:
Vintage Year
The vintage year affects the performance of private equity and venture capital investments due to the economic conditions at the time of initial investment.
115
Life Cycle Segments of a Private Equity Fund:
Investment Period
Typically the first five years, during which the fund sources capital from limited partners and invests in various companies.
116
Life Cycle Segments of a Private Equity Fund:
Harvesting Period
The remaining years when the fund exits existing investments and returns capital to limited partners.
117
Vintage Year
The year in which a private capital fund makes its first investment.
118
Ranking Asset By Risk:
1. Infrastructure Debt
2. Sr. Real Estate Debt
3. Unitranche Debt
4. Mezzanine Debt
5. Private-Equity Co Investments
119
The two categories of real property are:
A.residential and commercial.
B.privately held and publicly traded.
C.individual market and institutional market.
A.residential and commercial.
120
The preferred investment vehicles for public investors to own income-producing real estate are:
A. real estate funds.
B. mortgage-backed securities.
C. real estate investment trusts.
The correct answer is C. Real estate investment trusts (REITs) are the preferred investment vehicles for owning income-producing real estate for both private and public investors.
121
Which of the following entails the least risk?
A. Value-add real estate
B. Investment-grade commercial mortgage-backed securities
C.Residential real estate with long-term leases and many lessors
The correct answer is B. Of these three, investment-grade commercial mortgage-backed securities (CMBS) entail the least risk, and value-add real estate investments entail the most.
122
Which of the following entails the most risk?
A. Mezzanine debt
B. Core-plus real estate strategies
C.Redevelopment of an existing property
The correct answer is A. Of these three, mezzanine debt entails the most risk, and core-plus strategies entail the least.
123
The first stage of development of an infrastructure asset is typically called:
A. bluesky.
B. greenfield.
C.early stage.
The correct answer is B. The first stage of development of an infrastructure asset is typically called greenfield. Greenfield investing involves developing new assets and new infrastructure with the intention either to lease or sell the assets to the government after construction or to hold and operate the assets. Greenfield investors typically invest alongside strategic investors or developers that specialize in developing the underlying assets. The subsequent stages of development of infrastructure assets are typically called secondary stage and brownfield.
124
Direct infrastructure investment involves assets that are:
A.illiquid.
B.securitized.
C.exchange traded.
The correct answer is A. Like real estate, direct investment in existing infrastructure involves acquiring unique, illiquid assets with distinct location, features, and uses. Investors concerned about liquidity and diversification may invest indirectly using publicly traded infrastructure securities.
125
Which of the following types of infrastructure investments has the highest expected return?
A. Greenfield
B. Brownfield
C. Secondary stage
The correct answer is A. Greenfield investments offer the highest expected return of the three. They also entail the highest expected risk. Secondary stage offers the lowest expected return and the lowest expected risk.
126
Which of the following tends to make the largest allocations to the infrastructure asset class?
A. Pension funds
B. Sovereign wealth funds
C. Life insurance companies
The correct answer is B. Sovereign wealth funds tend to make the largest allocations to the infrastructure asset class—around 5%–6% of total AUM, according to Preqin.
127
Real Estate Categories:
Residential Real Estate
Includes single-family homes and multi-family units like condominiums, townhouses, and terraced housing. It is the largest sector by value and size.
128
Real Estate Categories:
Commercial Real Estate
Encompasses office buildings, retail shopping centers, warehouses, and rental properties. These properties are primarily used for income generation through leasing.
129
Real Estate Investment Structures:
Direct Investment
Involves purchasing and owning property directly. Advantages include control over investment decisions, potential tax benefits, and diversification. However, direct investment requires significant capital, specialized knowledge, and comes with liquidity and concentration risks.
130
Real Estate Investment Structures:
Indirect Investment
Involves investing through vehicles like REITs, limited partnerships, and mutual funds.
131
real estate investment trusts (REIT)
Tax-advantaged trusts that own, operate, and sometimes develop income-producing real estate property are known as real estate investment trusts.
pool resources from multiple investors to acquire income-generating properties, offering greater liquidity and diversification.
132
Real Estate Investment - Direct Investment:
High Initial Investment
Real estate investments typically require a large capital outlay.
133
Real Estate Investment - Direct Investment:
Heterogeneity
Each property is unique in terms of location, age, tenant mix, lease terms, and market demographics.
134
Real Estate Investment - Direct Investment:
Illiquidity
Real estate is not as easily bought or sold as stocks or bonds.
135
Real Estate Investment - Direct Investment:
Local Market Conditions
Real estate values are heavily influenced by local supply and demand factors.
136
Real Estate Investment - Direct Investment:
Price Discovery
The process can be opaque due to high transaction costs and limited market activity.
137
Real Estate Investment Trusts (REITs):
Equity REITs
Invest in properties and aim to maximize occupancy rates and rents while minimizing operating expenses to generate income.
138
Real Estate Investment Trusts (REITs):
Mortgage REITs
Invest in real estate debt or mortgage-backed securities.
139
Real Estate Investment Trusts (REITs):
Hybrid REITs
Combine both property ownership and mortgage investment.
140
Real Estate Investment Trusts (REITs):
Tax Advantages
REITs are preferred for their tax advantages and ability to avoid double taxation by distributing a significant portion of their income as dividends.
REITs can avoid corporate income taxation by distributing dividends equal to 90%–100% of taxable net rental income.
141
core real estate strategies
Strategies with exposure to well-leased, high-quality commercial and residential real estate in the best markets, generally offered by open-end funds. Investors expect core real estate to deliver stable returns, primarily from income from the property.
142
core-plus real estate strategies
Value-add investments that require modest redevelopment or upgrades to lease any vacant space together with possible alternative use of the underlying properties. Compared to core real estate strategies, these may be appealing for investors seeking higher returns and willing to accept additional risks from development, redevelopment, repositioning, and leasing.
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value-add real estate strategies
Strategies that involve larger-scale redevelopment and repositioning of existing assets and that may allow the investor to earn a higher return compared with core-plus real estate strategies.
144
True or false: The distinct and unique features of real estate make managing a real estate portfolio less complex than managing a portfolio of listed corporate bonds.
False. Selecting, valuing, acquiring, managing, and divesting a real estate portfolio is often more complicated than managing a portfolio made up of listed corporate debt. The heterogeneity unique to real estate demands specialized skills, and real estate markets are typically fragmented, with the local demand and supply conditions determining the value of the property.
145
The largest sector of the real estate market is:
A.residential real estate.
B. real estate investment trusts.
C.publicly traded mortgage-backed securities.
The correct answer is A. Residential real estate is by far the largest market sector by value and size. Savills World Research estimated in July 2018 that residential real estate accounted for more than 75% of global real estate values.
146
Describe the business strategy for equity REITs.
The business strategy for equity REITs is to maximize property occupancy rates and rents while minimizing ongoing operating and maintenance expenses to maximize cash income and dividends.
147
When a property title that is transferred to a new owner is unencumbered by any financing liens, such as from outstanding mortgages, the new ownership is considered:
A. privately held.
B.free and clear.
C.direct equity ownership.
The correct answer is B. “Free and clear” refers to the lack of any financing liens on a purchased property. If a direct private investor purchases a property and receives a title that is unencumbered by any financing liens, that ownership is considered free and clear.
148
Real Estate: Sources of Returns:
Income Generation
Primarily through rental or lease payments.
149
Real Estate: Sources of Returns:
Capital Appreciation
Increase in property value over time.
150
Real Estate: Risk/Return:
Low Risk / Low Return
Senior debt, first mortgages, investment-grade CMBS.
151
Real Estate: Risk/Return:
Med. Risk / Med. Return
Core, stable income-producing REITs
152
Real Estate: Risk/Return:
High Risk / High Return
Core-plus, value-add, and opportunistic real estate investments, including property development and distressed properties.
153
Real Estate: Benefits:
Income Stability
Long-term leases with fixed rents provide predictable income.
154
Real Estate: Benefits:
Inflation Protection
Lease payments are often adjusted for inflation.
155
Real Estate: Benefits:
Diversification
Real estate has historically shown low correlations with other asset classes, enhancing portfolio diversification.
156
Real Estate:
A Hybrid of Debt and Equity
Real estate investments offer a combination of bond-like and equity-like characteristics, providing steady cash flows and potential for capital appreciation. These investments can enhance the risk-return profile of a multi-asset portfolio, particularly during different phases of the economic cycle.
157
True or false:
Real estate historically has high correlations with other asset classes.
False. Real estate historically has low correlations with other asset classes.
158
In what ways are real estate investments similar to bond investments?
Predictable Income: Like bonds, real estate investments generate steady, predictable cash flows through rental or lease payments.
Inflation Protection: Lease agreements often include provisions for rent adjustments tied to inflation.
Stability: Real estate investments, particularly those with long-term leases, can provide stable returns similar to bond investments.
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In what ways are real estate investments similar to equity investments?
Capital Appreciation: Like equities, real estate investments can increase in value over time, providing capital gains.
Higher Risk and Return: More speculative real estate investments, such as development projects, carry higher risks and the potential for higher returns, akin to equity investments.
160
Infrastructure Investments:
Real and Capital-Intensive
Infrastructure assets are tangible, require significant capital, and have long lifespans.
161
Infrastructure Investments:
Public Use
Provide essential services like airports, healthcare facilities, and utilities.
162
Infrastructure Investments:
Cash Flow Sources
Income from availability payments, usage-based payments, and "take-or-pay" arrangements.
163
Infrastructure Investments:
Public-Private Partnerships (PPPs)
Long-term contracts between public and private sectors to deliver infrastructure projects.
164
Categories of Infrastructure Investments:
Economic Infrastructure:
Transportation Assets:
Roads, bridges, airports, seaports, railways.
165
Categories of Infrastructure Investments:
Economic Infrastructure:
ICT Assets
Telecommunication towers, data centers.
166
Categories of Infrastructure Investments:
Economic Infrastructure:
Utility and Energy Assets
Electrical grids, power generation, water production, gas storage and distribution.
167
Categories of Infrastructure Investments:
Social Infrastructure:
Educational Assets
Schools, universities.
168
Categories of Infrastructure Investments:
Social Infrastructure:
Healthcare Assets
Hospitals, clinics.
169
Categories of Infrastructure Investments:
Social Infrastructure:
Social Housing
Social Housing: Affordable housing projects.
170
Categories of Infrastructure Investments:
Social Infrastructure:
Government Buildings
Municipal offices, correctional facilities.
171
Stages of Infrastructure Development:
Greenfield Investments
Developing new infrastructure assets, often involving high risks and potential capital appreciation.
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Stages of Infrastructure Development:
Brownfield Investments
Expanding or upgrading existing facilities, with immediate cash flows and shorter investment periods.
173
Stages of Infrastructure Development:
Secondary-Stage Investments
Investing in fully operational infrastructure assets, providing immediate cash flow with lower risk.
174
Infrastructure cash flows primarily arise from:
A. dividends.
B. commercial tenants.
C. contractual payments.
C. contractual payments.
175
Economic infrastructure investments
A category of infrastructure investments that support economic activity through transportation assets, information and communication technology assets, and utility and energy assets.
176
Social infrastructure investments
A category of infrastructure investments that are directed toward human activities and include such assets as educational, health care, social housing, and correctional facilities, with the focus on providing, operating, and maintaining the asset infrastructure.
177
Most infrastructure assets are financed, owned, and operated by:
A. governments.
B. public–private partnerships.
C.development finance institutions.
The correct answer is A. Most infrastructure assets are financed, owned, and operated by governments, and a substantive proportion of these investments comes from public sources in the developing world. However, increasingly infrastructure is being financed privately through public–private partnerships by local, regional, and national governments. Infrastructure investments are also made in partnership with development finance institutions, which are specialized financial intermediaries that provide risk capital for economic development projects on a non-commercial basis.
178
Which of these statements about infrastructure investing is true? Infrastructure investments:
A. can generate cash income.
B.are intended to be non-profit.
C.do not have capital appreciation.
The correct answer is A. Investments in construction and development of new infrastructure are made with expectations to generate cash either from income or from capital appreciation.
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Which of the following is a characteristic of direct investment in infrastructure?
A. High liquidity
B. Concentration risk
C. Short-term horizon
The correct answer is B. Direct investment in infrastructure requires a large investment and results in both concentration and liquidity risks while the assets are managed and operated. Because of these risks and the typical long-term horizon, direct infrastructure investment usually takes place with a group or consortium of strategic investors that share the financial risk and/or assume a specific role in building, operating, or managing the assets.
180
Infrastructure Investments:
Developing Markets
Developing Markets: Infrastructure investments in emerging markets carry higher risks but offer higher potential returns over long time horizons.
181
True or false:
Greenfield infrastructure projects in developing countries offer exceptional return opportunities over very long time horizons.
True
182
Which of these types of infrastructure investment has the highest expected risk?
A. Regulated industry
B.Social infrastructure
C.Demand-based infrastructure
Demand-based infrastructure investments have the highest expected risk of the three. Social infrastructure has the lowest.
183
Which of the following has the highest weighting to capital appreciation?
A. Greenfield assets with limited construction and demand risk
B. Fully constructed brownfield assets with contracted revenues
C.Greenfield assets without guarantees of demand upon completion
The correct answer is C. Greenfield projects without guarantees of demand upon completion—for example, variable electricity prices, uncertain traffic on roads and through ports—have a high weighting to capital appreciation. Greenfield assets with limited construction and demand risk have a mix of yield and capital appreciation. Brownfield assets with mitigated risks (e.g., fully constructed with contracted/regulated revenues) that are located in the most stable OECD countries have a high weighting to current yield.
184
Which of the following is true regarding infrastructure investments?
A. Infrastructure investments typically generate volatile cash returns.
B.Infrastructure investments typically support services that face inelastic demand and/or benefit from high barriers to entry.
C.While public infrastructure returns have low correlation with market returns, private infrastructure returns have high correlation with market returns.
The correct answer is B. Because infrastructure investments typically support services that face inelastic demand and/or benefit from high barriers to entry, generate steady cash returns, and have a longer life cycle, equity investments in infrastructure offer lower correlation to public market equities and the broader economy. It is notable that public and private infrastructure returns exhibit low correlations.
185
Which of the following asset characteristics is shared by both farmland and real estate investments?
A. Both are liquid investments.
B.Both are illiquid investments.
C.Physical improvements are a primary focus of the investment value for both.
B is correct. Farmland and real estate share a feature of illiquidity: It is costly to find a buyer when sale of the investment is desired.
186
Which of the following natural resource investments is least likely to use the real estate investment trust (REIT) ownership structure?
A.Farmland
B.Raw land
C.Timberland
B is correct. Raw land is typically acquired through direct ownership or a partnership structure. Also, raw land has no inherent income stream and returns accrue purely from price appreciation, making the income pass-through REIT structure less relevant.
187
Which type of investor is likely to prefer investing in commodities using exchange-traded products?
A.Those seeking simplified trading through a brokerage account
B.Those seeking to gain access to dynamic commodity trading strategies
C.Those seeking expertise in a specific commodity sector
A is correct. Exchange-traded products allow investors to gain commodity exposure through a simple exchange-traded instrument that can be accessed via a brokerage account.
188
Which of the following describes a non-cash benefit of holding a physical commodity rather than a derivative contract on the same commodity?
A. Interest
B. Convenience yield
C. Storage
B is correct. In market environments in which physical inventories of a commodity become low, investors in that commodity will prefer to hold the physical asset rather than a derivative contract with the asset as an underlying. The premium on the spot price resulting from this preference is called the convenience yield
189
Which of the following statements most correctly reflects commodity supply and demand fundamentals?
A. Supply of commodities adjusts equally to demand for commodities.
B. Supply of commodities adjusts more rapidly than does demand for commodities.
C. Supply of commodities adjusts more slowly than does demand for commodities.
C is correct. Commodity supply adjusts slowly to demand because of long production times; for example, agricultural crops require a growing cycle.
190
Which of the following measures is best used to assess the potential for portfolio diversification when adding farmland or timberland to a portfolio of traditional assets?
A. Returns of other asset classes
B.Volatility of other asset classes
C.Correlation between other asset classes
C is correct. Correlation between asset classes best reflects the potential for portfolio diversification. An asset class that exhibits lower (i.e., closer to zero) correlation with traditional asset classes (such as stocks and bonds) has better diversification potential compared to an asset class exhibiting higher (i.e., closer to one) correlation.
191
Raw Land:
Characteristics
Involves the purchase of undeveloped land. Return drivers include land price appreciation and potential lease revenue. Risks include the best alternative use of the land and market demand for development.
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Farm Land:
Characteristics
Involves agricultural land used for growing crops or raising livestock. Return drivers include harvest quantities, commodity prices, and land price appreciation. Risks include weather factors, climate change, and biological factors such as diseases.
193
Timberland:
Characteristics
Involves forested land used for timber production. Return drivers include biological growth, harvest quantities, lumber prices, and land price appreciation. Risks include weather factors, climate change, and pest infestations.
194
Natural Resources:
Direct Ownership
Investors directly own the land and manage its operations, such as farming or timber harvesting. This form provides control but requires significant capital and specialized knowledge.
195
Natural Resources:
Indirect Ownership
Investors participate through investment funds, REITs, or partnerships. This form offers diversification and professional management but less control.
196
Natural Resources:
Sources of Return
Returns come from income generated by selling crops, timber, or leasing land, as well as potential price appreciation of the land itself.
197
Natural Resources:
Farmland:
Investment Features
Generates returns from crop sales and lease payments. The income is often subject to variability due to weather and market conditions. Farmland investments also provide inflation protection and tend to be less correlated with financial market volatility.
198
Natural Resources:
Timberland:
Investment Features
Provides flexibility in harvesting times, allowing investors to adjust to market conditions. Timberland generates returns from selling trees and other timber products. The biological growth of trees contributes to steady income over time.
199
Natural Resources:
Climate Risks
Both farmland and timberland are sensitive to weather and climate changes. Strategies to mitigate these risks include diversifying investments geographically and using advanced management techniques.
200
Natural Resources:
ESG Opportunities
Investments in natural resources often align with environmental, social, and governance (ESG) objectives, such as sustainability and carbon sequestration.
201
Identify the three primary return drivers of investing in timberland.
The three primary return drivers of investing in timberland are:
(1) the biological growth of the timber to be harvested in the future,
(2) the price of lumber, and
(3) changes in the price of the land.
202
Which of the following statements provides the most accurate description of timberland investment management organizations?
A.TIMOs are entities that use their forest investment expertise to analyze and acquire suitable timberland holdings on behalf of institutional investors.
B.TIMOs are investment funds that raise money from individual investors to buy timberland.
C.TIMOs are entities that only facilitate direct ownership of timberland by institutional investors.
A is the correct response. Timberland requires asset-specific expertise, and TIMOs use their expertise to analyze and acquire timberland holdings either directly or indirectly for institutional investors.
203
timberland investment management organizations
Entities that support institutional investors by managing their investments in timberland by analyzing and acquiring suitable timberland holdings.
204
Describe one important similarity and one important difference between investing in timberland versus investing in real estate.
Similarities between timberland and real estate include the fact that both asset classes involve investing in unique assets with distinct geography and the fact that both asset classes have a high degree of illiquidity.
An important difference between the two asset classes is the degree to which value reflects physical improvements to the land. Specifically, real estate investing values actual and potential improvements while timberland investing does not.
205
Describe a significant difference in the income component of farmland investing versus timberland investing
Timberland provides flexibility in the timing of harvesting trees.
Unlike timberland, farm products must be harvested when ripe, with little flexibility in production.
206
Commodities:
Characteristics
Commodities are physical goods that do not generate cash flows on their own but can incur costs such as transportation, storage, and insurance.
207
Commodities:
Investment Methods:
Derivatives
Most commodity investments are made through financial derivative instruments like futures, forwards, and options, due to the high costs and logistical challenges of holding physical commodities. Futures contracts are commonly used, which obligate the holder to buy or sell a specific amount of a commodity at a future date.
208
Commodities:
Investment Methods:
Exchange-Traded Products (ETPs)
Exchange-Traded Products (ETPs): These include ETFs and ETNs, which track the price of commodities or commodity futures. They offer liquidity and ease of trading.
209
Commodities:
Investment Methods:
Commodity Trading Advisers (CTAs)
Managed futures funds that invest in commodity futures based on technical and fundamental strategies.
210
Commodities:
Investment Methods:
Specialized Funds
These include private energy partnerships and publicly available energy mutual funds, which focus on specific commodity sectors.
211
Commodities:
Commodity Pricing
Commodity prices in derivative markets are influenced by the cost of carry (storage, transportation, and insurance costs) and convenience yield (non-cash benefits of holding the physical commodity).
212
Commodities:
Backwardation
When the spot price is higher than the forward price, usually due to high convenience yield.
213
Commodities:
Contango
When the forward price is higher than the spot price, typically because the cost of carry exceeds the convenience yield.
214
Commodities:
Sources of Value
Primarily generates value from price appreciation of the commodity itself. Investors benefit from changes in commodity prices, but do not typically receive income from holding the commodity.
215
Explain why low inventories of a commodity may result in backwardation for the commodity.
Low inventories of a commodity indicate a higher convenience yield because holders of the physical commodity benefit from the assurance of availability in a tight supply market.
This high convenience yield can outweigh the cost of carry, resulting in a higher spot price compared to the forward price, creating a backwardation scenario.
216
Commodities:
Supply Dynamics
Determined by production (hard commodities), seasonal crop yields (soft commodities), and inventory levels. Supply adjustments are slow due to factors like growing cycles and infrastructure development.
217
Commodities:
Demand Dynamics
Driven by end-user needs and investor actions, which can influence short-term price movements.
218
Commodities:
Return Drivers
Price appreciation driven by supply-demand imbalances and speculative investor behavior.
219
Commodities:
Risks
High volatility, geopolitical factors, and natural phenomena. Commodity prices are influenced by global economic cycles and investor speculation.
220
Commodities:
Inflation Protection
Commodities can serve as an inflation hedge, especially during periods of rising inflation.
221
Which statement about hedge funds is most accurate?
A.Hedge funds are investment products offered to the public and are traded daily on the OTC market.
B.Hedge funds are benchmarked to an index or industry/sector, and managers use complex strategies to mimic the index or industry/sector.
C.Hedge funds are private pooled funds, applying strategies with a goal of maximizing returns while reducing risk.
C is correct. A hedge fund is a pooled investment vehicle that uses complex trading (using leverage, short selling, using derivatives, etc.) and risk management techniques to enhance performance for a private group of accredited investors.
222
Which of the following statements about relative value strategies is least accurate?
A.Relative value strategies seek to profit from a price or return discrepancy between securities based on a short-term relationship.
B.Relative value funds are inherently structured to minimize net market risk and credit risks.
C.The investments made under a relative value strategy are all within a single asset class or sector, using assets with a sufficient price differential to arbitrage their movements to equilibrium prices.
C is the least accurate.
223
Which of the following statements is least accurate about hedge funds?
A. Merger arbitrage strategies generally assume that an acquirer will be overpaying for the target.
B.Event-driven hedge funds flourish in a stable market environment, where minor deviations in asset prices quickly converge to equilibrium.
C.An activist strategy expects to realize higher returns due to the manager being more effective in driving the corporate policies or strategic direction of the investment.
B is correct because it is the least accurate statement. Event-driven hedge funds thrive in a rising market environment with a high level of corporate activity in a strong economy.
224
Which of the following is not a characteristic of hedge funds?
A. Hedge funds are mostly illiquid, with little trading possibilities.
B.Hedge fund managers use leverage; however, the overall risk is lower.
C.Hedge funds are a different asset class, with a distinct risk/reward profile.
D.Managers demand higher remuneration and have more discretionary freedom in the choice of investments.
C. Hedge funds invest in traditional asset classes but use a specific investment strategy. They are not a distinct asset class.
225
In January, HedgeAway, a new hedge fund, started operations with an initial amount of USD100 million. The fund charges a management fee of 1.6% based on end-of-year value and a performance fee of 18% on gross returns payable on the excess over a hurdle rate of 8% after fees. The fund ended the year with assets under management (AUM) of USD120 million. What was the investors’ return during the year?
Management fee = 1.6% of 120 million = 1.92 million.
Growth during the year = 20 million, excess over the hurdle
= 20 million – (100 million × 0.08) – 1.92 million = 10.08 million.
Performance fee = 10.08 million × 0.18 = 1.81 million.
Total fees = 1.92 million + 1.81 million = 3.72 million.
Return to the investors = 20 million – 3.72 million = 16.38 million.
Investors’ return = 16.38%.
226
Hedge Funds:
Investment Approach and Objectives
Hedge funds use a variety of strategies involving traditional debt and equity instruments, leverage, derivatives, and short selling to generate high returns.
They aim for absolute returns or high risk-adjusted returns, often evaluating performance against an absolute return standard rather than a benchmark.
227
Hedge Funds vs. Mutual Funds:
Fees
Mutual funds managers receive fixed compensation, whereas hedge fund managers are paid performance-based fees and often invest in the fund.
228
Hedge Funds vs. Mutual Funds:
Availability
Hedge funds are available only to institutional and accredited investors, unlike mutual funds that are highly regulated and available to the public.
229
Hedge Funds:
Investment Strategies:
Equity Hedge Funds
Long/short equity, market neutral, fundamental growth, fundamental value, and short biased.
230
Hedge Funds:
Investment Strategies:
Event-Driven Funds
Merger arbitrage, distressed/restructuring, special situations, and activist.
231
Hedge Funds:
Investment Strategies:
Relative Value Funds
Convertible bond arbitrage, fixed income (general and high yield), and multi-strategy.
232
Hedge Funds:
Investment Strategies:
Opportunistic Funds
Macro strategies and managed futures
233
Hedge Funds:
Risk Management
Hedge funds utilize active management and integrated risk management to generate alpha and uncorrelated risk-adjusted returns. They implement strategies to insure against significant losses and help stabilize market volatility within a diversified portfolio.
234
Hedge Fund vs. Private Equity:
Availability
Both are structured as private partnerships for high-net-worth individuals, use leverage, and are less liquid and less regulated than mutual funds or ETFs.
235
Hedge Fund vs. Private Equity:
Time Horizons & Liquidity
However, hedge funds typically invest with a shorter time horizon and in more liquid asset classes, while private equity funds invest for the long term in fewer companies.
236
Hedge Funds:
Key Drivers of Returns
Market volatility and market inefficiency.
237
Hedge Funds:
Fee Structure
Traditional hedge funds often use the "two and twenty" fee structure, where the management fee is 2% and the performance fee is 20% of net profits.
238
Hedge Funds:
Indirect Investment Forms:
Fund of Hedge Funds
These funds pool investor money and invest in a diversified portfolio of hedge funds, offering benefits like diversification, lower investment minimums, and better liquidity. However, they come with higher fees due to the additional layer of management.
239
Hedge Funds:
Indirect Investment Forms:
Exchange-Traded Products (ETPs)
These funds replicate hedge fund investment styles using liquid assets and quantitative tools, offering greater liquidity, lower fees, and increased transparency compared to direct hedge fund investments.
240
Hedge Fund Structures:
Separately Managed Accounts
For larger investors, the hedge fund structure could be a fund of one or a separately managed account (SMA).
These are separate investment accounts over which the investor retains more influence.
241
Separately Managed Accounts:
Advantages
Customizable portfolios, better transparency, efficient capital allocation, higher liquidity.
242
Separately Managed Accounts:
Disadvantages
Operational complexity, potential reduced manager motivation, conflicts of interest, less personal investment by managers.
243
Hedge Fund Structures:
Master-Feeder Structure
The master feeder structure is set up for optimum tax efficiency and consists of an offshore feeder fund and an onshore feeder fund—both feeding into a master fund that invests the capital based on its contractual partnership agreements.
244
Hedge Fund Sources of Return:
Market Beta
General market return
245
Hedge Fund Sources of Return:
Strategy Beta
Return based on the hedge fund's investment strategy applied to the market.
246
Hedge Fund Sources of Return:
Alpha
Manager-specific returns due to identifying mispriced securities, timing the market, operational control, and leverage.
247
Hedge Fund:
Fees
High fees reduce the alpha generated
248
Hedge Fund:
Performance Benchmarks
Hedge fund indexes often use self-reported data, which can introduce biases (selection bias, survivorship bias, backfill bias).
249
Hedge Fund:
Comparison Challenges
Illiquidity and complex strategies make performance comparison and benchmarking difficult.
250
Hedge Fund:
Risk Characteristics
Hedge funds employ various instruments and leverage, making risk attribution complex.
251
Hedge Fund:
Long-Term Performance
Historically, hedge funds have had higher returns than stocks or bonds with similar volatility to bonds
252
Hedge Fund:
Index Biases
Selection bias, survivorship bias, and backfill bias can lead to overestimated performance in hedge fund indexes.
253
Hedge Fund:
Historical Performance
Hedge funds have shown to perform well during market downturns, offering diversification benefits.
254
Hedge Fund:
Correlation
Hedge funds generally exhibit low correlation with traditional asset classes like stocks and bonds, enhancing portfolio diversification.
255
Hedge Fund:
Equity Strategies
Fundamental value, market neutral, fundamental growth, and short bias.
256
Hedge Fund:
Event-Driven Strategies
Merger arbitrage, distressed/restructuring, special situations, activist.
257
Hedge Fund:
Relative Value Strategies
Convertible bond arbitrage, fixed income, multi-strategy.
258
Hedge Fund:
Opportunistic Strategies
Macro, managed futures
259
Hedge Fund:
Direct investments
master-feeder, SMAs,
260
Hedge Fund:
Indirect Investment
Funds of hedge funds and hedge fund replication ETFs
261
Hedge Fund vs. Traditional Portfolio
Hedge funds focus on alpha and strategy beta, contrasting with traditional portfolios that focus on market beta.
262
Distributed ledger technology (DLT)
Technology based on a distributed ledger.
263
Distributed ledger
A type of database that can be shared among entities in a network.
264
consensus mechanism
The consensus mechanism is the process by which the computer entities (or nodes) in a network agree on a common state of the ledger. Consensus generally involves two steps: transaction validation and agreement on ledger update by network parties. These features enable the creation of records that are, for the most part, considered immutable, or unchangeable, yet they are transparent and accessible to network participants on a near-real-time basis. There are various approaches to establishing consensus.
265
DLT Features:
Cryptography
An algorithmic process to encrypt data, making the data unusable if received by unauthorized parties.
266
DLT Features:
Smart Contracts
Computer programs that are designed to self-execute on the basis of pre-specified terms and conditions agreed to by parties to a contract.
267
Blockchain
A type of digital ledger in which information is recorded sequentially and then linked together and secured using cryptographic methods.
268
consensus protocol
A set of rules governing how blocks can join the blockchain that is designed to resist attempts at malicious manipulation up to a certain level of security; it can be either a proof of work or a proof of stake.
269
consensus protocol:
proof of work protocol
The proof of work protocol determines which specific block to add through a computationally costly lottery. The PoW consensus mechanism used to verify a transaction involves a cryptographic problem that must be solved by some computers on the network (known as miners) each time a transaction takes place.
270
consensus protocol:
miners
A validator of transactions on the blockchain that locks blocks of transactions into the blockchain and receives compensation for this process in the form of a digital asset.
271
consensus protocol:
Proof of Stake (PoS) Protocol
This protocol requires selected participants on the networks, the validators, to pledge capital to vouch for the block's validity. This stake signals to the network that a validator is available to verify the veracity of a transaction and propose a block.
272
DLT:
Permissionless Networks
Networks that are fully open to any user on a DLT network.
The main benefit of a permissionless network is that it does not depend on a centralized authority to confirm or deny the validity of transactions, because this takes place through the chosen consensus mechanism. This means no single point of failure exists because all transactions are recorded on a single distributed database and every node stores a copy of the database. Once a transaction has been added to the blockchain, it cannot be changed, barring manipulation; the distributed ledger becomes a permanent and immutable record of all previous transactions. In a permissionless network, trust between transacting parties is not a requirement.
273
DLT:
Permissionless Networks:
Bitcoin
Bitcoin is a well-known use of an open permissionless network. Bitcoin was created in 2009 to serve as the public ledger for all transactions occurring on its virtual currency. Since the introduction of Bitcoin, many more cryptocurrencies, or digital currencies, which use permissionless DLT networks, have been created.
274
DLT:
Permissioned Networks:
network members might be restricted from participating in certain network activities. Controls, or permissions, can be used to allow varying levels of access to the ledger, from adding transactions (e.g., a participant) to viewing transactions only (e.g., a regulator) to viewing selective details of the transactions but not the full record. Exhibit 3 compares the salient features of permissioned and permissionless blockchains.
275
cryptocurrency
An electronic medium of exchange that lacks physical form.
276
central bank digital currencies (CBDCs)
A tokenized version of the currency issued by the central bank, such as a digital bank note or coin, and a digital liability of the central bank.
277
tokenization
The process of representing ownership rights to physical assets on a blockchain or distributed ledger.
278
non-fungible token (NFT)
A unique cryptographic token on the blockchain that cannot be replicated and is used to represent ownership of physical assets, such as artwork, real estate, or other assets.
279
Security tokens
Digitizes the ownership rights associated with publicly traded securities.
280
initial coin offering
An unregulated process whereby companies raise capital by selling crypto-tokens to investors in exchange for fiat money or another agreed-upon cryptocurrency.
281
utility tokens
Tokens that provide services within a network, such as paying for services and network fees.
282
Governance tokens
In permissionless networks, governance tokens serve as votes to determine how the particular network is run.
283
Which of the following is not a potential benefit of distributed ledger technology?
A. Facilitation of smart contracts
B.Energy-efficient way of record keeping
C.Immutable and secure transaction records
The correct answer is B. Distributed ledger technology provides greater accuracy, transparency, and security in record keeping; enables faster transfer of ownership; and enables peer-to-peer interactions. A DLT network relies on certain consensus mechanisms in which all nodes that are connected on the network agree on new transactions and ledger updates. Once verified by all the nodes of the network, the transaction ledger is immutable and is kept by each of the nodes. However, the transaction validation process requires material computational power of all the miners on the network, especially in the case of proof-of-work consensus protocol.
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The process where a node on a blockchain network pledges its digital asset to verify a new block’s validity is called:
A. tokenization.
B. proof of work.
C. proof of stake
The correct answer is C. This proof-of-stake protocol requires selected participants on a blockchain network, the validators, to pledge digital assets to vouch for the block’s validity. This stake signals to the network that a validator is available to verify the veracity of a transaction and propose a block. Other validators who stake a digital asset to the network must then attest to the validity of proposed block. Validators benefit from both proposing and attesting to the validity of blocks that have been proposed by other participants in a similar staking process in the form of new digital assets.
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Digital Assets:
Inherent Value
Generally do not have inherent value based on underlying assets or expected cash flows. Their prices are driven by perceived scarcity and potential future transfer value.
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Digital Assets:
Transaction Validation
Transactions are recorded on decentralized digital ledgers using cryptographic algorithms.
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Digital Assets:
Medium of Exchange
Limited use as a medium of exchange in mainstream financial systems; not legal tender in most jurisdictions.
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Digital Assets:
Legal and Regulatory Protection
Legal and regulatory frameworks are still evolving and often unclear, leading to higher speculative value.
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Digital Assets:
Bitcoin (BTC)
Designed as an alternative to traditional currencies for secure P2P payments. It's the most widely traded cryptocurrency.
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Digital Assets:
Altcoins
Examples include Ether (ETH), which offers programmable blockchain capabilities, and other smart contracts.
291
Digital Assets:
Stablecoins
Designed to maintain stable value by linking to another asset (e.g., fiat currency, precious metals) or using algorithms to control supply. They facilitate settlement and cross-border trading but lack legal exchange for fiat money.
292
Digital Assets:
Meme Coins
Cryptocurrencies created for entertainment, often driven by social media popularity (e.g., Dogecoin).
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Digital Assets:
Stablecoins:
Collateralized Stablecoin
Backed by financial assets like fiat currencies or commodities (e.g., Tether, USD Coins).
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Digital Assets:
Stablecoins:
Algorithmic Stablecoin
Maintain value using algorithms rather than collateral (e.g., TerraUSD).
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Cryptocurrency Exchanges:
Centralized Exchange
Centralized Exchanges:
1. Operate like traditional stock exchanges.
2.Provide trading platforms for cryptocurrencies, offering volume, liquidity, and price transparency.
3.Centralized control means higher risk of security breaches.
4.Some are regulated, depending on jurisdiction.
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Cryptocurrency Exchanges:
Decentralized Exchange
Decentralized Exchanges:
1.Lack centralized control and operate on a distributed platform.
2.More secure against attacks as they have no single point of failure.
3.Harder to regulate, which can allow for potentially illegal activity.
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Cryptocurrency:
Risks:
Fraud and Manipulation
Includes scam ICOs, pump and dump schemes, and market manipulation.
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Cryptocurrency:
Risks:
Loss of Access
Losing access to a digital wallet passkey can make holdings irretrievable.
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Cryptocurrency:
Risks:
Whales
Large holders of cryptocurrencies who can manipulate the market.
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Cryptocurrency:
Direct Investment
Cryptocurrency Wallets and Exchanges
Initial Coin Offerings (ICOs)
Trading on Exchanges
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Cryptocurrency:
Indirect Investment
Cryptocurrency Coin Trusts
Cryptocurrency Futures Contracts
Cryptocurrency ETFs
Cryptocurrency Stocks
Hedge Funds
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Decentralized Finance (DeFi)
DeFi is a marketplace for decentralized applications (dApps) that allows for financial transactions to take place and to be recorded on the blockchain without a central coordinating mechanism.
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Which of the following is not a risk in direct investment in digital assets?
A.Market manipulation
B.Pump and dump schemes
C.Failure to validate asset transfers
he correct answer is C. There are several risks with direct investment in cryptocurrencies, including the risk for fraud, such as scam ICOs, pump and dump schemes, market manipulation, theft, and schemes that seek to gain access to credentials needed to access cryptocurrency wallet information. However, transactions in digital assets such as cryptocurrencies and tokens are verified and authenticated by cryptographical algorithms and consensus protocols. Once a transaction is entered between the parties, it becomes validated on the blockchain and creates a permanent record of the transaction. Therefore, the DLT technology makes it very unlikely to fail validating asset transfers.
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Bitcoin: Returns, Volatility, Correlation
Bitcoin has shown high returns but also high volatility and low correlation with traditional asset classes, making it a unique investment.
The volatility of Bitcoin remains significantly higher than traditional financial assets like the S&P 500 Index.
