ASSET ALLOCATION TO ALTERNATIVE INVESTMENTS

Question 1

Compare direct lending (private debt) vs public debt

Answer 1

Direct lending and public debt have pretty much the same risk/return profile, except that private debt has an extra risk premium based on liquidity.

Question 2

Describe the risk/return profile of distressed debt (private credit)

Answer 2

Risk/return profile that is similar to equity. Factors that affect specifically the issuer have a greater effect on debt’s performance than factor that affect fixed income in general.

Question 3

For a short term horizon, which asset class would be best to combined with a long equity position.

Answer 3

Risk of investor in short term time horizon = volatility. Hence, to reduce volatility, we have to reduce the correlation with asset class. Bonds tends to exhibit the lowest correlation with equity.

Question 4

For a long term horizon, which asset class would be best to combined with a long equity position.

Answer 4

Risk of investor in long term horizon = failing to achieve a minimum required rate of return. Hence, bonds combined with equity increase the risk that returns will fall below that minimum required rate.

In this case, alternative investment would be best. They give a higher returns than bonds and still exhibit potential diversification with equity.

Question 5

Explain the different traditional approaches to defining the investment opportunity set including alternative investments.

Answer 5

1. Liquidity based approach : Distinguish publicly traded alternative investment such as futures contract or REITs with not publicly traded. For the not publicly trade, you will classify them in term of how long the capital must be committed.
2. Another approach is to classify assets on how they will perform under different scenarios of economic growth and inflation.

Question 6

Explain the basis of a risk factor based approach for defining asset classes

Answer 6

Involves statistics to estimate the sensibility of asset class to risk factor (economic growth, inflation, interest rates, credit spread, currency values)

Question 7

Describe the differents advantages/disadvantages of risk factor based approach

Answer 7

Advantages :

• Identifying sources of risk that are common across asset classes.
• By allowing the manager to analyze multiple dimension of portfolio risk, it helps at developing an integrated risk management framework.

Disadvantage :

• Managers that uses this approaches must be aware that the risk factor estimate might be sensitive to the period used for analysis.
• The results might also be more difficult to communicate to decision makers.

Question 8

Explain the concept of gates in a limited partnership structure.

Answer 8

Gates are imposed by the general partners and are maximum amounts that can be redeemed at any one time.

Question 9

How can we detect that returns are smoothed when modeling risk and returns properties of alternative investments.

Answer 9

We can test those data for a serial correlation.

Question 10

Identify the use of Monte Carlo simulation when it comes to optimize asset allocation

Answer 10

1. Decide what you want to analyze between asset class returns or risk factors
2. Define how the model should behave, for example by accounting for properties like mean reversion, fat-tailed distributions, or unstable correlations.
3. If the model is based on risk factor, translate them to asset class returns.
4. Use the resulting asset class returns scenarios to develop meaningful outputs.

Question 11

Identify a simple model to estimate the capital contribution of a limited partnership structure in a specific period.

Answer 11

% of capital to be called in period t * (committed capital - capital previously called)

Question 12

How to estimate the expected distribution made by a limited partnership structure

Answer 12

% to be distributed in period t * ((NAV t-1 * (1 + growth))

Question 13

Identify an approach to help mitigate the opportunity cost of having enough capital to meet capital calls

Answer 13

Keeping these amounts in cash equivalents has significant opportunity costs. A suggested approach is to invest it in publicly traded securities that may be viewed as proxies for the private investments to which they are committed. For example, capital committed to private real estate but not yet called could be invested in publicly traded real estate investment trusts.

Question 14

Explain why comparing a manager alternative investment portfolio to peers or a benchmark might be misleading

Answer 14

Because it doesnt mean that it represent out portfoio. Alternative investment strategies are highly based on active management, any benchmarks chosen is unlikely to be comparable with the portfolio.

Question 15

Discuss why monitoring of alternative investment can be challenging

Answer 15

-performance reporting exhibit time lag and are infrequent

• Often report IRR rather than time weighted rates or return. IRR can be easily manipulated.

Question 16

What other approaches would be better for monitoring a private funds return

Answer 16

Using Multiple in invested capital (MOIC) = Value of underlyings investments + distribution/ total invested capital