CAIA Book 1 Flashcards
What are the three super asset classes?
- Capital Assets
- Assets that are used as inputs to create value
- Assets that are used as a store of value
What is asset allocation?
Asset allocation refers to the selection of asset classes for a portfolio. The four primary asset classes are equity, fixed income, cash and real estate
What is strategic asset allocation?
A portfolios long term policy allocation that is derived from the investors risk aversion and the long term risk/ return characteristics of the primary asset classes
What is tactical asset allocation?
Tactical asset allocation refers to the short term portfolio allocations that differ from the strategic asset allocation in order to take advantage of current market conditions. Alternative assets fit into tactical asset allocation
What is constrained investing?
Constrained investing has restrictions that limit their efficiency. After the end of the prolonged bull market in 2000, institutional investors sought out un constrained alternative investments in order to increase returns
What is the distinct difference between the returns for mutual funds and the returns for hedge funds?
Mutual fund returns are primarily based on asset location, while hedge fund returns are primarily based on trading strategy. Risk exposures for mutual funds relate to asset location, while risk exposures for hedge funds relate to trading strategy
What are the three primary differences between alternative assets and domestic equities that affect efficiency?
Alternative assets must be purchased from a financial intermediary (limited liability company or a limited partnership)
Alternative assets are less liquid than equities
Alternative assets are unconstrained, while typical equity investments face constraints
What are beta drivers?
Beta drivers are exposures to market risk factors
What are alpha drivers?
Alpha drives are exposures to Active Return factors
What investment products are beta drivers?
Passively managed index funds
Semi active index funds
Active long only investments
130/30 funds
What are the six major categories of alpha drivers?
Long/short investments Absolute return investments Segmented Markets Non linear return distributions Alternative Beta Exposure Portfolio Concentration
What are long/short investments?
Market neutral investments (zero beta)
Long/short investments not fully hedged (non zero beta)
Ability to short stocks
What are absolute return vehicles?
Not constrained, manager can pursue alpha wherever he thinks it exists.
Totally unconstrained investment style
What are Segmented Markets?
These are investments that investors normally avoid ie below investment grade securities. Sometimes investment restrictions prohibit an IM from investing in these type of securities in the normal investment universe
What are non linear return distributions?
Includes investments with non linear return distributions. ie options
What are alternative beta exposures (cheap beta)
Includes a category of systematic risk exposures beyond stocks and bonds. Risk exposures include currencies and commodities
What is portfolio concentration?
Large bet on fewer securities. Concentrated portfolios assume greater tracking error in an attempt to produce larger active returns
What are the types of beta investments?
Classical Beta Bespoke Beta Alternative Beta Fundamental Beta Cheap Beta Active Beta Bulk Beta
What is Bespoke Beta
Considered custom beta because it can be divided many ways……ie sector, style, size, country.
ETF’s is an example of Bespoke Beta
What is Classical Beta?
Measures the exposure of a security relative to a major market index. ie index mutual fund tracking S&P 500
What is Alternative Beta?
Measure of exposure to alternative systematic risks
Low correlation to stocks and bonds
ie ETF’s that invest in currency futures
What is fundamental beta?
Based on new concept that capitalization weighted indices create increased demand for large cap stocks to the exclusion of smaller capitalized weighted indices.
This has led to the theory that large cap stocks are overvalued and smaller cap stocks are undervalued. Therefore new indices created based on dividend payout etc
What is the result of differing index construction methods on fundamental beta?
Endogenous alpha
What is endogenous alpha?
Excess returns relative to a standard index that is realized as a result of differing index construction
What is exogenous alpha?
Excess returns realized through actively managing a Fund
What is cheap beta?
Convertible bonds have multiple systematic risk exposures (interest rate risk, equity market risk, credit risk, option volatility risk).
A convertible arbitrage hedge fund purchases convertible bonds and hedges exposure equity market risk, and option volatility risk leaving interest rate and credit risk.
These funds are selling expensive beta and retaining cheap beta
What is Active Beta?
Funds that use quantitative tools to earn excess returns from equity market anomalies.
ie 130/30 funds and TAA
What is Bulk Beta?
Includes standard actively managed funds. They offer a combination of systematic risk exposure (beta), and active risk exposure (alpha).
Linearly related to their benchmarks
What two conditions are necessary to compute an active manager’s alpha?
Returns in the regression should be excess returns
Factor returns should be returns available to investor with low to zero costs ( the benchmarks should be investable)
What are product innovators?
Investment managers that develop new and innovative alpha driven investment products
What are Process Drivers?
Process drivers are investment managers that attempt to refine processes and procedures for beta driven products to reduce costs
What do balanced mandate managers attempt to do?
Deliver beta and attempt to extract alpha from beta exposures.
What are the conditions necessary for multi factor models to work?
Work when the appropriate risk exposures are specified in the model
What are the implications for investment managers that use multi factor models?
Managers should distinguish between returns generated by alpha and beta
Investment managers should be open to investors about their investment process and how returns are generated
How can the alpha estimation process be improved?
Understanding of investment product or strategy being analyzed
What assumptions must hold for alpha to be a zero sum game?
Identical investment horizons Identical risk tolerances No market segmentation Homogeneous expectations about risk and return Zero taxes or equal taxes for all
Is alpha a zero sum game?
The determination of alpha being a zero sum game is dependent on those assumptions, Hereford alpha may not be a zero sum game
What are the three types of information asymmetry?
The level of investment manager skill is only known ex ante by the investment manager
Investors only receive periodic summaries of their portfolios, reducing the transparency of their investment product
The actual risk exposures of a fund are known by the investment manager, but may not be known by the investors
What are some asymmetries regarding incentives?
Alternative asset managers - the performance fee is a call option on the performance of the fund, which the fund managers are actually paid to hold via the management fee
Traditionally managed investment - since alpha receives higher compensation managers have an incentive to nit be clear about actual risk exposures of the fund
What is risk taking asymmetry?
Alternative asset managers have an incentive to engage in excessive risk taking
What are three ways that asymmetries can be addressed?
Products that deliver beta exposure should have minimal cost to reflect the limited skill required to capture beta
Alpha and beta should be separated so that the content of alpha and beta in products is transparent
Managers should have transparency in their investment management process
Thee is a trade off between alpha and transparency of the investment management process
Because of the incentives for managers to accept excessive risk, investors should require a certain level of transparency in risk exposures
What are some business models likely to be available in the future?
Firms with beta focused products
Firms with alpha focused products
Firms that provide investment solutions
Firms that provide a collection of specialized investment products
What is the information ratio?
A risk adjusted measure of an active manager’s return
What is the Sharpe Ratio?
Measures excess returns relative to a standard deviation (total risk), which is normally attributable to a benchmark
What are the two ways that the information ratio differs from the Sharpe Ratio?
The numerator is the mean return in excess of the benchmark, not returns in excess of the risk free rate
The denominator is the standard deviation of alpha, not the standard deviation of total returns
What is the information coefficientient?
The IC is a measure of the managers skill at forecasting
What is meant by the term breadth?
The number of independent forecasts of alpha that are made in a year
What is the transfer coefficient?
Measures the amount of information not lost due to investment constraints and transaction costs involved in portfolio implementation
What are traditional investments normally affected by?
Long only constraints and transaction costs, whereas alternative investments do. It face long only constraints but are subject to transaction costs
How do 130/30 products partially relax the constraints found in traditional investment products
Going long in positive alpha securities 130% of NAV, and short in negative alpha securities 30% of NAV.
Why have 130/30 funds attracted significant attention to date?
The potential for greater alpha and higher information ratios
What are some of the advantages of REITS?
REITS avoid double taxation by passing all in one and capital gains through to shareholders
REITS shares are traded on stock exchanges and can be purchased using margin
Strategic or tactical allocations to real estate can be achieved using REITS
REIT managers are skilled at evaluating, acquiring! managing! financing! and developing properties
REITS produce steady income for shareholders
Independent board of directors monitor managers
What are some of the disadvantages of REITS?
Public stock exchange listing increases REIT systematic risk and reduces the diversification benefits from adding REITS to a portfolio
REIT dividends are subject to ordinary income tax rates, which is problematic for investors in high tax brackets
Define the following types of REITS:
Equity REIT
Mortgage REIT
Hybrid REIT
Equity REIT owns equity of underlying properties, returns are derived from rents and increases in property values
Mortgage REITS invests in loans used to finance property purchases. Returns are derived from interest earned on loans in the portfolio
Hybrid REIT combines equity and mortgage payments
Define: Single property REIT, finite life REIT, Dedicated REIT,
Single property REIT is the purchase of one large property using pooled investor funds
Finite life REIT the properties are sold at the end of the REIT’s life normally 8-15 years
Dedicated REIT focuses on a single property type, a geographic region, or one development
Define UPREIT, Down REIT, and Market Focus
An UP REIT indirectly owns property through an operating partnership. New investors defer capital gains by exchanging properties for equity ownership in the subsidiary partnership.
A Down REIT is where an existing REIT creates and transfers properties to a partnership. New investors exchange additional properties for equity ownership in the subsidiary partnership. The new investors defer capital gains taxes on the properties and gain access to a diversified pool or real estate.
Market focus concentrates investments by property types, geographic areas, or size of investment.
What are some of the conditions for a REIT’s pass through tax status?
Income requirements: 75% or more of REIT gross income must be derived from real estate, 95% or more of REIT income must be derived from dividends and interest, security sales, and the sources for the 75% test
Asset requirements: 75% or more of REIT assets must be held in real estate, cash, government securities, or temporary investments; 25% or less of REIT assets may be invested in another issues securities, but must not be greater than 5% of its assets or 10% of its voting shares.
What are some of the conditions for a REIT’s pass through tax status?
Distribution requirements- 95% or more of REIT taxable income must be distributed
Corporate structure - must be a corporation, at least one trustee/director must manage the REIT; no more than five investors may own more than 50% of shares; must be at least 100 owners; must be able to transfer shares, cannot be an insurance or financial firm
What are the three economic benefits of REITS?
Favourable Sharpe Ratios as indicated by historical performance. Over the period 1997-2008, REIT’s performance had the second highest return and Sharpe ratio of any asset class despite having the absolute highest standard deviation. REITs also have significant exposure to outlier events and significant exposure to downside risk
Significant diversification potential. REIT’s generally have low correlations with large cap stocks, T bills , and inflation, as well as negative correlations with 10 year T Bonds
Potential to hedge against inflation, especially over long periods of time.
What does the composite NCREIF Property Index contain in terms of properties?
Office 36.6% Apartments 24.1% Retail 22.1% Industrial 15.3% Hotel 2%
What are the two methods in which appraisals can be conducted?
Comparable Sales Method: sales of similar properties are analyzed to determine a price per square foot, which is adjusted to reflect the characteristics of the property
Discounted Cash Flow Method: Property cash flows are projected into the future and then discounted back to the current period to determine the property value.
What are the major problems with appraisal based indices?
Appraisal values tend to lag market values.
Returns also do not capture the effects of leverage
Both appraisal methods are backward looking
Smoothed NPI returns has three practical effects! what are they?
Lagging values (NPI changes the lag in the real estate market)
Low volatility overstates risk adjusted performance
Low correlation overstates potential diversification benefits
What are the four methods of up smoothing NPI?
Use current transactions - recalculate using only properties that actually sold in the most recent quarter
Use revalued properties - recalculate using properties that were revalued due to a significant event
Create a hedonic pride index - attribute the total price change from actual transactions to the property characteristics, simulate price changes for non transacted properties, and then recalculate using simulated and actual price changes
Econometric adjustments - un smooth index prices using an econometric model (moving average of current and prior period values) that accounts for appraisal behavior and then recalculate returns on the index
What are the assumptions that we should make regarding real estate investments?
Should provide: ample cash flows earn a return in excess of RFR Serve as an inflation hedge Allows the portfolio to better reflect the global investment opportunity set Diversify the portfolio
Do REIT’s provide an inflation hedge?
No
What does correlation analysis reveal about REIT investing?
Has strong diversification and inflation and hedging potential when combined with a traditional portfolio of stocks and bonds
What are the inflation protection effects of:
Retail NPI
Industrial NPI
Retail NPI has the most inflation protection
Industrial NPI has inflation protection but to a lesser extent
Do traditional asset classes and REIT’s provide inflation protection?
No
What is the portfolio effect of adding either direct real estate investment or a REIT to a portfolio of stocks and bonds?
It improves the efficient frontier, however direct real estate investment provides the greatest improvement
What are the three primary real estate investment styles?
Core
Value Added
Opportunistic
What is meant by Core Investment Style?
Office, retail, apartments, and industrial real estate properties. Highest liquidity, lowest leverage, more developed, held for long time periods, returns are dependent on cash flows; fully operating; high occupancy, low rollover concentration, low near term rollover, high market recognition, meaningful or direct control.
What is meant by Value Added Investment styles?
Resorts, hotels, hospitals, assisted living facilities, outlet malls, low income residential properties. Returns stem from cash flows, and price appreciation, operating and leasing, moderate occupancy and rollover concentration
What is meant by Opportunistic Investment Style?
Include properties that require significant development or a turnaround, high risk and return expectations, 3-5 year time horizon. Returns generated by price appreciation, significant rollover risk, new construction and development, low occupancy, high rollover concentration, high near term rollover, low market recognition, minimal control.
What are the risk and return objectives for real estate styles?
Core: 9-10% with volatility of 11%. Relative return investors expect a return equal to the NPI
Value added: 10-13% with volatility in the same range. Relative return investors expect a return plus 200 basis points
Opportunistic: >13% with similar volatility. Relative investors expect a return equal to the NPI return plus 500 or more basis points
What is the real estate investment styles?
15.85%
What is the range of returns for Core Style investments?
8.3%-19.1%
What is the range of returns for Value Added Investments?
-2.1%-8.3% in the new leasing strategy or repositioning phase
&
19.1-23.4% range after successful completion of the stage
What is the range of returns for Opportunistic style investments returns
Returns should be below -2.1% while capital is invested in repositioning, development, redevelopment, or restructuring strategy and above 23.4% once the strategy is successfully completed.
What are Private Equity Real Estate (PERE)
A good way for investors to gain exposure to opportunistic and value added real estate, especially in foreign markets.
PERE funds typically have a complex capital structure, and a higher level of risk resulting from leverage, zoning risk and public policy risk, development risk, currency risk, tenant risk, and property turnaround risk
Valuation of PERE properties is difficult due to the lack of disclosure requirements, property purchases below their true potential and sale transaction data during real estate market downturns.
Compared to mutual funds, hedge funds are:
Are private investment vehicles for sophisticated investors
Have more concentrated portfolios with a fewer number of holdings
Use derivatives more frequently
May take long or short positions in securities
Use leverage sometimes in large amounts
Invest in private placement securities
What are the four primary categories of hedge funds?
Market Directional
Corporate Restructuring
Convergence Trading
Opportunistic
What is a market directional hedge fund?
Maintain some degree of market risk exposure that causes these funds to be impacted by market conditions
What is a Corporate Restructuring fund?
Attempts to profit from corporate events such as bankruptcies and mergers
What is Convergence Trading?
Strategies that take offsetting long and short positions in similar securities to profit from a narrowing of the spread between the two securities.
What is an Opportunistic hedge fund?
Strategies that take advantage of whatever opportunities exist in the market place
What are equity long/ short strategies?
Combine long stock positions with short positions to construct a portfolio with reduced exposure to market risk
What is normally the net position of equity long/ short strategies?
They tend to be net long in their exposure to market risk
How do fundamental equity long/ short strategies work?
Analyze business prospects of companies within an industry from a bottom up perspective
What are quantitative equity long/ short strategies?
Use complex multi factor models to select securities
What is the goal of short selling strategies?
To maintain a net short exposure to the market in an attempt to profit from market declines
What is Activist Investing?
Holding a few concentrated long only equity positions and becoming actively involved in the company in order to improve corporate governance
What is Distressed securities investing?
Investing in securities of companies that are bankrupt or are likely to go bankrupt
What is Capital Structure Arbitrage?
A form of distressed security strategy that is based on the hierarchy of claims in a bankruptcy liquidation
What is Merger Arbitrage investing?
Purchase stock of a firm that is target of a takeover and selling the stock of the acquiring firm in an attempt to capture the spread between the pre merger and post merger prices of the companies
What is the main source of return for a Merger/ Arbitrage strategy?
Positive changes in the value of the target firm and the negative change in value of the acquiring firm
What is the main source of return for Event Driven strategies?
Accurate prediction of the occurence of an event within the given time frame of the investment
What is an Event Driven strategy
Event Driven strategies attempt to profit from the mispricings associated with one time specific company events
What is a Fixed Income Arbitrage strategy?
Taking a long position in one fixed income security, and a short position in a related fixed income security, profits are earned as the spread between the two securities converges over time
What are Regulation D Hedge Funds?
They purchase private securities of public companies
What do MBS attempt to capitalise on?
MBS security arbitrage attempt to capitalise on pricing discrepancies in the MBS market
What are the main risk exposures for MBS’
Duration, convexity, yield curve rotation, prepayment risk, credit risk, liquidity risk
What is a Convertible Bond Arbitrage Strategy?
Going long in company’s convertible bonds, and hedging the associated equity exposure by taking a short position in the company’s common stock
What determines the appropriate mix of convertible bonds and short positions in the underlying common stock
The hedge ratio or delta
What are the components of total return?
interest on bonds, short rebate, change in the value of the bond, change in the value of the underlying stock, interest on borrowing
What are the main risk exposures of Convertible Bond Arbitrage Strategies?
Leverage, liquidity risk, interest rate risk, model risk, credit risk, call risk, and event risk
What are the main risk exposures of Convertible Bond Arbitrage Strategies?
Leverage, liquidity risk, interest rate risk, model risk, credit risk, call risk, and event risk
What is the calculation for the number of shares needed to be shorted to hedge a Delta position?
shares of stock = number of convertible bonds x conversion ratio x hedge ratio
Define market neutral strategies
Take long and short positions in securities with the objective of eliminating market risk, leaving security selection as the sole source of return
What is the rule of one alpha?
There is only one source of risk adjusted return
There is only one source of risk adjusted return
Holding equal amounts of long and short positions so the manager has a zero net exposure to the market
What are factor models?
Complex regression equations that relate security returns to one or more specific variables
What is relative value arbitrage?
any strategy that attempts to profit from a relative mispricing between two securities
What is a stub trading strategy?
Stock based strategies that involve the piece of an equity security that is left over from a merger recapitalisation
What is the goal of Volatile Arbitrage Strategies?
Capitalize on differences in the implied volatility that exists between option prices on a particular stock
What are Global Macro Strategies?
Look for opportunities anywhere in the world and will invest in any country or any type of security
Why has the popularity of Global Macro strategies been reduced?
Significant losses from the Russian bond default in August 1998 and the technology bubble of 2000
