CFA L2 Alternative Investments Flashcards
Fundamental analysis vs technical analysis
Fundamental analysis focuses on financial statements and economic indicators to assess an asset’s intrinsic value, making it more suitable for long-term investment decisions. Alternatively, technical analysis examines share price movements and trends to identify investment opportunities.
Tools used in fundamental analysis to predict supply and demand shocks:
- Announcements
- Component analysis: Different products that make up the commodity class are the components of that commodity. Analysis of demand and supply forecasts of components aid the forecasts for the aggregate.
- Timing issues: Incorporating any seasonality and previously observed logistical issues can refine estimates of demand/supply.
- Macroeconomic indicators
Commodity sectors
- Energy: Crude oil, natural gas, and refined products.
- Industrial metals
- Grains
- Livestock
- Pecious metals: gold, silver, and platinum
- Softs (cash crops): coffee, sugar, cocoa, and cotton
Crude oil/petroleum
A natural liquid prodcut found under the ground. Light oil (low viscosity) and sweet oil (low sulfur content) are less costly to refine and, therefore, sell at a premium relative to heavier or higher sulfur crude oils. Crude oil can be stored indefinitely by keeping it in the ground and is also stored in tanks and aboard tanker ships and is cheap to ship. Many countries store large amounts of crude oil as strategic reserves. Economic cycles also affect the demand for oil, which is higher during expansions when credit is widely available and can decrease sharply when contractions lead to reductions in the availability of credit. Improvements in the efficiency of alternative sources of energy production have also reduced the overall growth in the demand for oil. Increasingly stringent restrictions on oil exploration and production in response to environmental concerns have tended to increase the cost of oil production and decrease supply. Political risk is an important factor in oil supply. Over half the crude oil supply comes from countries in the Middle East, and conflict there can reduce supply dramatically.
Refined products (ex: gasoline, heating oil, and jet fuel)
These products are only stored for short amounts of time. Seasonal factors affect the demand for refined products in that greater vacation travel in the summer months increases gasoline demand, and colder weather in the winter increases the demand for heating oil. Since refineries are located in costal areas, hurricanes and extreme whether cause periodic refinery shutdowns.
Natural gas
Unlike crude oil, natural gas can be used just as it comes out of the ground with very little processing. Natural gas can then be transported through a pipeline but can also be transported on a ship. Natural gas must be liquified to be transported by ship, significantly increasing the cost of transport. Cold winters increase the demand for gas for heating fuel. Hot summers increase the demand for gas as well (for cooling) because gas is a primary source of fuel for electrical power generation.
Associated gas vs unassociated gas
Associated gas: Natural gas extracted w/ crude
Unassociated gas: Natural gas that is extracted where there is no crude extracted
Industrial metals (ex: aluminum, nickel, zinc, lead, tin, iron, and copper)
Demand for industrial metals is tied to GDP growth and business cycles. Storage of metals IS NOT costly. Political factors, especially union strikes and restrictive environmental regulations, can have a significant effect on the supply of an industrial metal. Industrial metals must be smelted from mined ore. Both mines and smelters are large-scale operations with high development costs and high fixed costs.
Grains
Grown over an annual cycle and stored, although multiple crops in a single year are possible in some areas. The risks to grain supply are the usual: droughts, hail, floods, pests, diseases, changes in climate, and so on.
- Grains have uniform, well-defined seasons and growth cycles specific to geographic regions.
Precious metals
Can be stored indefinitely. Gold has long been used as a store of value and has provided a hedge against the inflation risk of holding currency. Jewelry demand is high where wealth is being accumulated. Industrial demand for precious metals is sensitive to business cycles.
Livestock
Supply of livestock depends on the price of grain since grain is used to feed the animals. Weather can affect the production of some animals. Disease is a source of significant risk to livestock producers, and some diseases have had a large impact on market prices. Income growth in developing economies is an important source of growth in demand for livestock. Freezing allows the storage of meat products for a limited amount of time.
- Livestock production is strongly influenced by seasonality
Softs/cash crops
Just as with grains, weather is the primary factor in determining production (cash crops are only grown in warm climates) and price, but disease is a significant risk as well. Demand increases with increases in incomes in developing economies but is dependent on consumer tastes as well.
Valuation of commodities
Commodities are physical assets and have no CFs. The spot price of a commodity can be viewed as the discounted value of the expected selling price at some future date. Storage costs for commodities can lead to forward prices that are higher the further the forward settlement date is in the future.
Participants in commodities futures markets
- Hedgers: investors who long or short futures contracts. Hedgers “do in the futures market what they must do in the future” (ex: A wheat farmer needing to sell wheat in the future can hedge price risk by selling futures contracts. A grain miller will need to buy wheat in the future and can hedge price risk by buying futures contracts.
- Traders/investors: Either speculators or arbitrageurs (seek to profit from mispricing in the forward market).
- Exchanges: Provide a venue for trading and gaurentee trades
- Analysts: Analysts are considered non-market participants. Perform analysis for data firms, government forecasts, etc.
- Regulators
The basis of a contract
The difference between the spot price and a futures price
Formula: S0 - F0
Calendar spread
The difference between the futures price of a nearer maturity and the futures price of a more-distant maturity.
Contango
When futures prices are higher at dates further in the future (F0 > S0)
- In a contango market, the calendar spread and basis are negative.
- When a futures market is in contango, long futures positions have a negative returns component
Backwardation
When futures prices are lower at dates further in the future (F0 < S0)
- The basis and calendar spread are positive.
- When a futures market is in backwardation, long futures positions have a positive returns component
3 theories of commodity futures returns
- Insurance Theory
- Hedging Pressure Hypothesis
- Theory of Storage
Insuance Theory
Created by John Maynard Keynes. The thoery states that commodity producers wanting to reduce their price risk is what drives commodity futures returns. Producers reduce uncertainty by writing short contracts on commodities which drives down futures prices. This theory states that the futures prices will be less than current spot prices to provide a return to speculators. The idea is that investors are getting return for providing insurance to producers’ price risk fears. The result of this is usually backwardation and the situation is called normal backwardation.
This theory lacks two empirical findings: first, buying futures has not resulted in the extra returns the theory says buyers should receive for providing “insurance.” Second, many markets are NOT in backwardation, but rather in Contango- which means investors get negative return for providing insurance.
Hedging Pressure Hypothesis
This is an add-on to the Insurance Theory. This theory states that producers who will sell their product in the future will short the commodity to hedge against price risk, while users who need inputs will use long forward contracts to reduce price risk. The more commodity users hedge w/ long future contracts, the more upward price pressure there is on the futures price. Under the Hedging Pressure Hypothesis, when producers’ hedging behavior dominates, the market will be in backwardation, and when users’ (people who will need to buy inputs) hedging behavior dominates, the market will be in contango.
Shortcomings of this theory: first, producers typically face more concentrated price risk than consumers: individual consumers will spend only a small portion of their income on a single commodity. Second, both producers and consumers may be speculators in the market, not just hedgers. Lastly, hedging pressure is not observable, so we cannot directly test the hypothesis that relative hedging pressure is the cause of backwardation and contango.
Theory of storage
This theory states that whether a futures market is in backwardation or contango depends on the relationship between the costs of storing the commodity for future use and the benefits of holding physical inventory of the commodity. When the costs of storage outweigh the benefits of holding physical inventory, futures are more attractive than current inventory, futures will trade at a higher price than spot, and the market will be in contango. Conversely, when the benefits of holding physical inventory outweigh the costs of storage, current possession is more attractive than future possession, spot prices are higher than futures prices, and the market will be in backwardation. The benefits of holding physical inventory is called convenience yield.
Formula: Futures price = spot price + storage costs - convenience yield
- F0 > S0 when storage costs are high
- F0 < S0 when convenience yield is high
True or false: A commodity is most likely to be stored by a physical exchange?
False, a commodity is most likely to be physically stored by an arbitrageur. Arbitrageurs may store a physical inventory of a commodity to exploit differences between spot and futures prices relative to the costs of storing the commodity
3 components of total return on a fully collateralized long futures position:
- Collateral return
- Price return
- Roll return
Collateral return/Collateral yield
When a futures portfolio is fully collateralized, the investor must post cash or acceptable securities w/ a value equal to the notional value of the futures contract. If U.S. Treasury bills are deposited as collateral, the return is the holding period return on the T-Bills.
Price return/Spot yield
The change in spot prices (which can be proxied by futures prices on near-month contracts).
Price return = (current price - previous price) ÷ previous price
Roll return/Roll yield
Since commodity derivative contracts expire, an investor who wants to maintain a position over time must close out the expiring futures position and reestablish a new position with a settlement date further in the future. This process is referred to as rolling over the position and leads to gains or losses which are termed the roll return.
Roll return = (price of expiring futures contract - price of new futures contract) ÷ price of expiring futures contract
- The roll return can be positive if the futures price curve is in backwardation or negative if the futures price curve is in contango.
- To hold the value of a long position constant, an investor must buy more contracts if the new longer-dated futures are trading at a lower price (market in backwardation) and buy fewer contracts if the new longer-dated futures are trading at a higher price (market in contango).
True or false: Swaps are used to increase or decrease exposure to commodities risk?
True
Total return swap
Used to hedge commodities risk. The swap buyer (the long) will receive periodic payments based on the change in the futures price of a commodity plus the return on the collateral, and will pay a series of fixed payments. Each period, the long will receive the total return on holding the commodity times a notional principal amount, net of the payment promised to the short. If the total return is negative, the long makes the promised fixed payment percentage plus the negative return percentage on the commodity over the period, times the notional amount.
Total return swap example:
Investor A initiates a total return swap on oil w/ a notional value of $10MM in which for two years the long must pay 25 basis points monthly and will receive the total return on the WTI.
(1) If over the first month the price of WTI increases from 41.50 bbl to 42.10 bbl (+1.45%), what will the long pay/receive?
(2) If over the second month the price of WTI decreases from 42.10 to 41.20 (–2.14%), what will the long pay/receive?
(1) (0.0145 - 0.0025) * $10MM = $120,000 - Investor A will receive $120,000
(2) (-0.0214 - 0.0025) * $10MM = -$239,000 - Investor A will pay -$239,000
Excess return swap
A party may make a single payment at the initiation of the swap and then receive periodic payments of any percentage by which the commodity price exceeds some fixed or benchmark value, times the notional value of the swap. In months where the commodity price does not exceed the fixed value, no payments are made.
Basis swap
The variable payments are based on the difference between the prices of two commodities. This is often done when one commodity has liquid future contracts available and the other doesn’t. Because the price changes of the two commodities are less than perfectly correlated, the difference between them (the basis) changes over time. By combining a hedge using the liquid futures with a basis swap, the swap buyer can hedge the price risk he faces from the input that does not have a liquid futures market.
Volatility swap
The underlying factor is the volatility of the commodity’s price. If the volatility of the commodity’s price is higher than the expected level of volatility specified in the swap, the volatility buyer receives a payment. When actual volatility is lower than the specified level, the volatility seller receives a payment.
Dimensions of a commodity index
- Which commodities are included
- The weighting of the commodities in the index
- The method of rolling contracts over as they near expiration
- The method of rebalancing portfolio weights
- With regard to roll methodology, a passive strategy may be to simply roll the expiring futures contracts into the near-month contract each month. A more active strategy would be to maximize roll return by selecting the further-out contracts with the greatest backwardation or smallest contango.
Which dimension(s) have the greatest impact on the index’s return?
Components included in the index and weighting characteristics
True or false: Frequent rebalancing of portfolio weights may decrease index returns in trending markets or increase index returns in choppy or mean-reverting markets?
True
Public real estate vs private real estate
Public real estate: Ownership usually involves a direct investment such as purchasing property or lending money to a purchaser. Direct investments can be solely owned or indirectly owned through partnerships where the GP provides property management services and LPs are investors
Private real estate: Does not involve direct investment, but rather ownership of securities: REITs, REOCs, and MBSs.
- Private RE investments are usually larger than public investments because real estate is indivisible and illiquid.
- Public RE are usually more liquid and allow investors more diversity.
Characteristics of RE
- Heterogenity: No two properties are exactly the same (this is esp. true w/ commercial properties)
- High unit value: Because RE is indivisible, the unit value is significantly higher than stocks and bonds, which makes it difficult to construct a diversified portfolio.
- Active mgmt: Private RE requires active mgmt
- High transaction costs: appraisals, brokers, etc.
- Depreciation and desirability
- Cost & availability of debt capital
- Lack of liquidity
- Difficulty in determining price: Because of the high costs to acquire and develop RE, property values are impacted by the level of interest rates and availability of debt capital. Real estate values are usually lower when interest rates are high and debt capital is scarce.
Key risks with CRE investment
- Supply and demand risks
* Business conditions
* Demographics
* Excess supply: If there is a market downturn, there could be a lack of CFs from a lack of rental income, and therefore excess supply. - Risks relating to valuation
* Cost and availability of capital: RE must compete with other investments for capital. Demand for RE is reduced when debt capital is scarce and interest rates are high. Conversely, demand is higher when debt capital is easily obtained and interest rates are low. Thus, RE prices can be affected by capital market forces without changes in demand from tenants.
* availability of info
* Iliquidity
* Interest rates - Operational risks
* Mgmt expertise
* Lease terms
* Leverage
* ESG considerations
* Obsolescence
* Market disruptions
* Other risk factors
Loan-to-value (LTV) ratio
The use of debt (leverage) to finance a RE purchase.
- Lower the better. Higher values mean higher risk.
Benefits of investing in RE
- Current income: Investors can collect rental incomes
- Capital appreciation: Investors usually expect property values to increase over time.
- Inflation hedge: During inflation, investors expect RE values to rise.
- Diversification: Can provide diversification outside of stocks and bonds
- Tax benefits: in the United States, the depreciable life of real estate is usually shorter than the actual life. As a result, depreciation expense is higher and taxable income is lower, resulting in lower income taxes. In addition, REITs do not pay taxes in some countries, which allows investors to escape double taxation
Core investing style
A conservative RE investment strategy that limits investments to high quality and low leverage (<30% LTV), and avoids speculative risks in favor of steady returns.
What are the low-risk commerical property types?
office, industrial/warehouse, retail, and multifamily.
- Hospitality properties (hotels and motels) are riskier because leases are not involved and performance is highly correlated with the business cycle.
Gross lease vs net lease
Gross lease: The owner is responsible for the operating expenses
Net lease: The leasee is responsible for the operating expenses. Rent under a net lease is lower than under a gross lease.
Triple-net lease (NNN)
Requires the tenants to pay their share of common area maintenance, repairs, property taxes, and building insurance.
Commercial property types
- Office: Demand is dependent on job growth
- Industrial: Demand is dependent on the overall economy.
- Retail: Demand is dependent on consumer spending, and therefore the overall economy.
- Multifamily residential: Demand dependent on population growth, esp. in the age demographic that typically rents apartments.
Percentage lease/percentage rent
Additional rent charged to a retail tenant once sales reach a certain level.
Minimum rent
The opposite of a percentage lease- it’s the rent paid by a retail tenant w/o regard to sales.
Multifamily residential
Any residential property w/ more than one housing unit.
Due diligence process for both private and public equity RE investment
- Review market to assess local demographics and economy
- Lease review and rental history
- Confirm operating expenses (do this by reviewing bills)
- Review CF statements
- Obtain an environmental report to identify possibility of contamination
- Perform an inspection to identify structural issues
- Examine maintenance/service agreements to identify any recurring problems
- Inspect the property’s title for any deficiencies.
- Have the property surveyed to confirm the boundaries and identify easements.
- Verify compliance w/ zoning laws, building codes, and environmental regs
- Verify payment of taxes, insurance, special assessments, and other expenditures
RE Indexes (Indices)
Track the performance of the RE asset class, including appraisal-based indices and transaction-based indices.
Appraisal-based indices
Indices based on appraisal values. A popular index in the U.S. is the NCREIF Property Index (NPI). Members of NCREIF, mainly investment managers and pension fund sponsors, submit appraisal data quarterly. After quarterly returns, the index is value weighted based on the returns of the separate properties. Appraisal-based indices tend to lag actual transactions because actual transactions occur before appraisals are performed. Thus, changes in prices may not be reflected in the index until the next quarter or even later depending on when the appraisal happens. Appraisal lags also tend to smooth the index. Appraisal lag also results in lower correlation w/ other asset classes. Appraisal lag can be adjusted by unsmoothing the index or by using a transaction-based index. The index return is equivalent to a single period IRR. Return is measured as current yield + capital gains yield.
Return = (NOI - CAPEX + (ending market value - beginning market value)) ÷ beginning market value
- The reason we use NOI instead of NI is that the value of RE should be independent of interest expense.
- NCREIF is a value-weighted index that is based on appraisal data.
Transaction-based index
Can be constructed using a repeat-sales index and a hedonic index. Repeat-sales index relies on multiple sales of the same property, whereas a hedonic index requires only one sale. A regression model controls for differences in property characteristics.
- Hedonic Index construction does not require multiple sales of the same property.
True or false: Publicly traded REITs usually appeal to small investors seeking exposure to professionally managed RE?
True
Types of publicly traded RE
- REITs
- REOCs
- MBSs
Equity REITs
REITs are tax-advantaged firms that are mostly exempt from corporate income tax. Equity REITs are actively managed and seek profit by growing CFs, improving existing properties, and purchasing additional properties.
- REITs often specialize in a particular type of property.
- Because REITs are not able to retain earnings as other companies do, REITs make frequent secondary equity offerings, in order to finance growth and property acquisitions.
Mortgage REITs
Primarily invest in mortgages, mortgage securities, or loans secured by RE.
Real Estate Operating Companies (REOCs)
An equity security that’s a non-tax-advantaged firm that owns RE. A business usually forms as a REOC if it’s ineligible to be a REIT. REITs are usually expected to payout 90% of their income to shareholders, but this is not the case w/ REOCs; instead, the money can be reinvested. REOCs can also invest in a wider range of property types.
- REOCs are subject to double taxation (not tax-advantaged)
- Directing privately in RE and REITs are both tax-advantaged while REOCs are not.
Residential or commercial MBS
Publicly traded ABSs that receive CFs from an underlying pool of residential mortgages (RMBSs) or commercial mortgages (CMBSs).
Structure of a REIT
Most REITs are set up as corporations or trusts. To be exempt from taxation, REITs must distribute 90%-100% (depending on the country) of their taxable income as dividends. REITs must invest make a 75% minimum investment in RE and derive at least 75% of their income from rental or mortgage interest to keep their title.
