Alternatives - R31 Flashcards
Describe common features of alternative investments and their markets and how alternative investments may be grouped by the role they typically play in a portfolio.
- Low liquidity
- Diversification benefits
- High due diligence costs
- Difficult to value
- Limited access to information
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
- Assess the organization of the manager
- Assess the people
- Assess the terms and structure of the investment
- Assess the service providers (i.e., lawyers, brokers, ancillary staff).
- Review documents, such as the prospectus and other memoranda
Explain the special issues that alternative investments raise for investment advisers of private wealth clients.
- Tax issues can be unique to the individual
- Determining the suitability of investments varies across individuals.
- Communication with the client is important because the client may no be knowledgeable enough to effectively communicate his/her needs.
- Decision risk is the risk of irrationally changing a strategy.
- Wealthy individuals frequently hold concentrated portfolios.
Distinguish among the principal classes of alternative investments, including:
- Real Estate
- Private Equity
- Commodities
- Hedge Funds
- Managed Futures
- Buyout Funds
- Infrastructure Funds
- Distressed Securities
List the direct/indirect methods of investment along with their benchmarks (next card).
Real Estate
-
Indirect investments include:
- Companies that develop and manage R/E.
- REITs
- CREFs
- Infrastructure Funds
- Direct investments in R/E generally have low liquidity, large size, high transaction costs, and asymmetric information
- Real estate provides diversification, but each individual asset may have large idiosyncratic risk.
Private Equity
- Direct: purchase investment directly from firm
- Indirect: PE funds, inc. VC/BO funds
Commodities
- Direct: buy the physical or derivative
- Indirect: through companies where the principal business is associated with a commodity.
Managed Futures
- Managed futures tend to trade only in derivatives markets (different than HFs). Limited Partnerships.
Buyout Funds
- Capture value by selling acquisitions through private placements or IPOs. Recapitalization also occurs.
- Middle-market and Mega-cap buyout funds exist - difference is size.
Infrastructure Funds
- Specialize in buying public infrastructure assets from governments.
- Tend to be regulated by local government, and have low correlation. Returns are typically low.
Distressed Securities
- Considered part of the hedge fund class, but sometimes PE class too. HF more liquid.
Discuss the construction and interpretation of benchmarks and the problem of benchmark bias in alternative investment groups.
-
Real Estate
- NCREIF; NAREIT
-
Private Equity
- Cambridge Associates; Thomson Venture Economics
-
Commodities
- DJ-AIG Commodity Index; S&P Commodity Index
-
Managed Futures
- MLMI; CTA indices
- Buyout Funds
- No benchmark - Check a HF/PE index?
- Infrastructure Funds
- No benchmark
-
Distressed Funds
- Similar to long-only HF benchmarks
-
Hedge Funds
- CISDM of UMass
- CS/Tremont
- EACM Advisors
- HF Intel
- HF.net
Describe and identify the list of providers of monthly hedge fund indices and their characteristics.
Discuss biases in hedge fund benchmarks.
There are a few monthly indices
CISDM of UMass - hedge/managed futures
Credit Suisse/Tremont - various
EACM Advisors - Equal weight of 100 funds
Hedge Fund Intelligence - EW of >50
FedgeFund.net - EW > 30
Biases exist because of the self-reporting nature.
Backfill/Inclusion bias - manager adds historical data
Popularity bias - funds in a value-weighted index attract more capital
Survivorship bias - indices may drop funds with poor track records or that fail
Evaluate the return enhancement and/or risk diversification effects of adding an alternative investment into a reference portfolio (for example, a portfolio invested solely in common equity and bonds)
Basically everything ex. P/E is a diversifier and everything ex Commodities is a return enhancer.
Real estate - High risk-adjusted performance is possible because of the low liquidity, large sizes, high transaction costs, and low information transparency that usually means the seller knows more than the buyer. Good diversification.
Private equity is less of a diversifier and more of a LT return enhancer.
Commodities offer diversification to a portfolio of stocks and bonds. The returns on commodities are generally lower than stocks and bonds.
Hedge funds generated higher returns than stocks and bonds over the period 1990-2004 and generally provide moderate to good diversification benefits.
Managed futures provide returns similar to that of hedge funds and can provide diversification.
Distressed securities have generally beaten stocks and bonds but have a large negative skew and are uncorrelated with the overall stock market.
Describe the advantages and disadvantages of direct equity investments in real estate.
Advantages
- Many expenses are tax deductible
- Ability to use more leverage than most other investments
- More control than stock investing
- Ability to diversify geographically
- Lower volatility of returns than stocks
Disadvantages
- Lack of divisibility
- High information commission, operating and maintenance, and management costs
- Special geographical risks
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, an the purpose of such financing.
Issuers of capital: formative-stage and expansion-stage companies.
Buyers of capital: angel investors, VCs, large companies (strategic partners)
Stages: Early (seed, start-up, first stage), Later (expand sales - 2nd/3rd/mezzanine), Exit (merger, acquisition, IPO)
Compare venture capital funds and buyout funds
In contrast to venture capital funds, buyout funds usually have:
- more leverage
- earlier/steadier cash flows
- less error in measurement of returns
- less frequent losses
- less upside potential
Discuss the use of convertible preferred stock in direct venture capital investment
Converts are a good vehicle for direct VC because they must be paid a specified amount before common stockholders receive distributions. Usually they get paid a multiple (eg. 2x), and have some sort of seniority. During a buyout/acquisition, they will convert to common shares.
Explain the typical structure of a PE fund, including the compensation to the fund’s sponsor (general partner) and typical timelines.
The typical structure is a limited partnership (LP) or limited liability company (LLC).
The sponsor gets a management fee and an incentive fee. the management fee is usually 1.5 to 2.5%, and based on the committed funds. Incentive fee aka carried interest. This is the share of the profits that are paid to the manager after the fund has returned outsider investors’ capital. A claw-back provision may be in place if the expected profits are not realized.
Discuss the issues that must be addressed in formulating a private equity investment strategy.
Any strategy for private equity investment must address:
- low liquidity
- diversification through a number of positions
- plans for meeting capital calls.
Compare indirect and direct commodity investments
Direct commodity investment entails either purchasing the actual commodity or gaining exposure via derivatives.
Indirect commodity investment is the purchase of indirect claims, like shares in a corporation that deals in the commodity.
Direct = more exposure, but can incur carying costs.
Indirect = more convenient, but less exposure - sometimes very little if a company is hedging.
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.
The components of the return to a commodity futures contract are the:
-
spot return
- aka price return - is the return on the futures casued by the change in the underlying commodity price.
-
collateral return
- aka collateral yield - approximately the risk free rate.
-
roll return
- aka roll yield - usually the result of normal backwardation.
total return = spot return + collateral return + roll return
-
upward-sloping = contango
- spot price < futures, so prices decline as they approach maturity. Negative roll yield.
-
downward-sloping = backwardation
- spot price > futures price, so prices converge as futures get closer to maturity. Positive roll yield.
