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CFA Level 3 > Asset Allocation to Alternative Investments > Flashcards

Asset Allocation to Alternative Investments Flashcards

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CFA flashcards
1
Q

What are the basic roles of private equity in a portfolio?

A

CG and Income generation

  1. Return enhancer over public equities - not a diversifier - capture illiquidity premium
  2. Volatility is not observed
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2
Q

What are the basic functional roles of alternative investments in a portfolio?

A
  1. CG’s
  2. Income
  3. Diversification
  4. Safety
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3
Q

What are the basic roles of hedge funds in a portfolio?

A

Really everything as hedge funds are expansive

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4
Q

Which hedge fund strategies would be considered return enhancers?

A
  1. L/S
  2. Global Macro
  3. Futures
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5
Q

Which hedge fund strategies would be considered diversfiers?

A
  1. Short bias
  2. Arb
  3. Event driven
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6
Q

What is the role of real assets in a portfolio?

A

Inflation protection in general

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7
Q

What is the role of timber in a portfolio?

A
  1. CG on land
  2. Income from Trees
  3. Inflation hedge
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8
Q

What is the role of commodities in a portfolio?

A
  1. Inflation hedge (core)
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9
Q

What is the role of farmland in a portfolio?

A
  1. CG on land
  2. Income from crops or rent
  3. Inflation hedge
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10
Q

What is the role of infrastructure in a portfolio?

A
  1. Capital gains
  2. income
  3. Capture illiquidity premium
  4. Inflation hedging
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11
Q

What is the role of commercial real estate in a portfolio?

A
  1. CG of property
  2. Inflation hedging
  3. Income from rent
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12
Q

What is the role of private credit in a portfolio?

A
  1. Income from direct lending

2. CG from distressed credits

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13
Q

What are the strengths and weaknesses of the traditional asset allocation approach?

A

Strengths:
1. Easy to understand
2. Relevant for liquidity and operational management
Weaknesses:
1. Diversification is not over risk factors just across asset classes
2. Obscures drivers of risk

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14
Q

What are the strengths and weaknesses of the risk based asset allocation approach?

A

Strengths:
Risk is much more integrated
Weaknesses:
Correlation to risk factors are nonstationary
How do you find a manager who only provides one risk factor?

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15
Q

What are the important things to consider when evaluating risk in AI?

A
  1. SD is not accurate
  2. Returns are chunky
  3. Illiquidity is a new risk
  4. Just because you invest today does not mean you get exposure - capital calls happen over time
    For all these reasons, asset allocation that is optimal is hard to implement
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16
Q

What are the important things to consider when evaluating returns in AI?

A
  1. Much more variable

2. Asset class history is almost irrelevant

17
Q

What are the important things to consider when evaluating vehicles in AI?

A
  1. Limited partnerships have high concentration, high minimums, and require expertise to select
  2. Fund of funds are less flexible and more expensive, but operationally efficient
  3. SMA’s - fund of one - Very high minimums - general partners have many funds they look at and can have twisted incentives (want to place goods investments in high fee accounts)
  4. Liquid ALTs - smaller minimums, but not a pure strategy due to regulatory restrictions
18
Q

What are the important things to consider when evaluating liquidity in AI?

A
  1. How liquid is the actual vehicle?

2. How liquid is the underlying asset?

19
Q

What are the important things to consider when evaluating fees in AI?

A
  1. Any extra pass through fees?

2. How are PE fees charged?

20
Q

What are the important things to consider when evaluating tax in AI?

A
  1. Are the funds target investors taxable?

2. How much control do you have over taxes?

21
Q

What is the suitable investment horizon for AI?

A

For private assets at least 15 years, for public lockups are usually at least a year.

22
Q

What are the three primary approaches of determine your allocation to alternatives?

A
  1. Monte Carlo

2. Optmization

23
Q

How do you use monte carlo simulations to allocate to alternatives?

A
  1. You can generate return scenarios that deviate from normality (M-CVaR optimization)
  2. Estimate long term risk profile
24
Q

How do you use optimization methods to allocate to alternatives?

A
  1. This will typically over allocate to AI if using MVO - to limit this you must establish constraints
  2. You can use Mean CVaR optimization
25
Q

What are the issues with interpreting AI return series?

A
  1. Way too smooth - you must solve the serial correlation problem - higher SC, bigger the issue
  2. Skewness and fat tails - underestimated downside risks. Negative skew creates downside risk.
26
Q

What is a regime switching model and how can it be used to simulate AI return series?

A

You can take two scenarios, each which are normally distribution, and simulate the combined distribution. This is done using MC simulations.

27
Q

When would you use M-CVaR vs MVO?

A
  1. If downside is most important, CVaR

2. If returns are not normally distribution, CVaR

28
Q

How do you achieve and maintain your target allocation to alternative investments? What would you consider?

A

There is no surefire way. You must consider

  1. how long does capital take to get called
  2. How much is it growing relative to other assets?
  3. When will distributions occur?
29
Q

How do we monitor an AI investor program?

A
  1. Are they hitting return goals?

2. Has the landscape changed since we committed capital?

30
Q

How do we evaluate AI performance?

A
  1. How do we benchmark - typically a custom benchmark or peer group
  2. How do we adjust for the lumpy timing of returns? Us IRR for longer periods of time, multiples of invested capital for short amounts of time.
  3. Understand that economics affect returns just as much as manager skill
31
Q

What should we monitor about the AI firm we choose to work with?

A
  1. Key person risk
  2. Alignment of interests
  3. Style drift?
  4. Do they have and abide by a risk management process?
  5. Client turnover
  6. Client profile - long term investors leaving
  7. Service providers

CFA Level 3 (28 decks)

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