Chapter 12 - Analysis of Non-Conventional Asset Classes and their Structures Flashcards
What is an Alternative Investment and why invest in them?
Alternative investments are asset classes that are different from the traditional three broad asset classes of equities, bonds and cash. There are three main reasons why an investor would include alternative investments in a portfolio:
- To incrementally increase returns more than incrementally increasing the risk.
- To incrementally decrease risk more than incrementally decreasing the return.
- To increase the absolute-return nature of the portfolio, making it more resistant to capital erosion in market downturns.
What are Hedge Funds?
Hedge funds are lightly regulated pools of capital with managers that have great flexibility in their investment strategies. Hedge fund managers are not constrained by the rules that apply to mutual funds or commodity pools (which are pools of money contributed by many investors to collectively invest in commodities). They can take short positions, use derivatives for leverage and speculation, perform arbitrage transactions (which exploit price differentials to make a profit) and invest in almost any situation in any market where they see an opportunity to achieve positive returns.
Describe Hedge Fund features?
Hedge funds differ from mutual funds in:
• the use of short selling, leverage and derivatives
• liquidity constraints and business risks.
What are the Hedge Fund Strategies?
- Relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related stocks, bonds or derivatives in different markets. Hedge funds using these strategies generally have low or no exposure to the underlying market direction, and their returns are due to the manager’s skill in identifying mispriced securities and other instruments and implementing arbitrage trades.
- Event-driven strategies seek to profit from unique events such as mergers, acquisitions, stock splits and stock buybacks. Hedge funds that use event-driven strategies have medium exposure to the underlying market direction. The manager focuses on assessing the implications of specific events and on timely implementation of market positions designed to profit from the most likely outcome of the event.
- Directional strategies bet on anticipated movements in the market prices of equities, debt securities, foreign currencies and commodities. Hedge funds using these strategies have high exposure to trends in the underlying market. The manager focuses on predicting and understanding the opportunities generated by trends in different market indicators. The manager then focuses on establishing positions designed to take advantage of the most likely direction in these indicators. The effects of the manager’s skill can be magnified through leverage.
What are Hedge Fund Risk Drivers?
- First-order risk refers to exposure to changes in the general direction of interest rates, as well as equity, currency and commodity markets. The source of risk is market-induced or systematic (which cannot be reduced through diversification). First-order risk does not affect relative value strategies or event-driven strategies to any significant degree. It does, however, affect directional strategies, which, by definition, are based on a hedge fund manager’s views about the direction of different markets, interest rates, commodity prices and currencies.
- Second-order risks include liquidity, leverage, deal-break, default, counterparty, trading, concentration, pricing model, security-specific and trading model risks. These risks, unlike first-order risk, are not related to the market but to other aspects of trading, such as dealing, implementing arbitrage structures, or pricing illiquid or infrequently valued securities.
- The third type of risk, operational risk, relates to the hedge fund as a business entity and stems from the fact that many hedge funds are small, newly created businesses that depend on one or more high-profile managers for their success. Such organizations are highly focused on promoting and supporting the skills of the manager(s) and may lack the organizational depth, managerial talent and strategic planning capabilities necessary to ensure growth or even survival. For most hedge funds, operational risk stems from potential system failures as well as faulty settlement, reporting and accounting procedures. Operational risk is significant in single-strategy funds and needs to be addressed through due diligence.
What are the types of commodities?
a. Grains and Oilseeds
b. Livestock and Meat
c. Forest, Fibre and Food
d. Precious and Industrial Metals
e. Energy Products
What is Private Equity?
Private equity is a rapidly growing market and is typically done through funds structured as limited partnerships (LPs). The promoters are the general partners, while the investors are the limited partners. Funds may be primary (a round of financing is raised for first-time investing in different opportunities) or secondary (invest by buying back positions held by primary investors needing to liquidate earlier than the maturity date). Private equity investments include leveraged buyouts, mezzanine capital, venture capital and infrastructure investments.
- Leveraged buyout: A leveraged buyout (LBO) occurs when the buyer of the majority of a company’s shares finances this purchase through debt, often with the assets of the acquired company used as collateral for the loan. LBO firms represent some of the wealthiest finance organizations anywhere, with the ability to raise funds above $10 billion and conduct multi- billion-dollar deals. LBO funds are structured as limited partnerships, with the general partners (the promoters of the fund) receiving ongoing compensation and the limited partners receiving returns contingent on investment performance.
- Mezzanine capital: A firm may wish to finance by floating high-yielding, unsecured preferred equity or subordinated loans. This mezzanine capital typically is just above common stocks in seniority. As such, they are a comparatively costly way to finance. From the private equity investor’s point of view, the risk of default is about the highest in the debt spectrum, but the investment pays high returns given the increased credit risk in case of default.
- Venture capital: Venture capital is applied to the financing of new, untested companies and business ventures. It also helps finance growing, early-stage companies (not yet mature or not ready to issue equity or debt in the mainstream markets) or struggling companies (called distressed investing). Because of the high risks involved, venture capitalists require the potential for very high returns and fully diversify their portfolios because several funded companies will terminate operations or business projects will not reach the market. Importantly, before investing, venture capitalists require that the firm present a clear exit strategy, showing how the venture capitalist will be able to divest the investment, either through an initial public offering (IPO) or an acquisition.
- Infrastructure: Investments in infrastructure represent massive amounts of capital with a small number of investing partners. Infrastructure refers to such projects as roads, ports, airports and water works. In Australia, Europe and North America, there is rapidly growing demand for private financing of public projects. A well-known Canadian example is the 407 highway in Toronto. The worldwide infrastructure market has been reserved for the very largest institutional investors, such as the Caisse de Depot’s ownership stake in Heathrow Airport Holdings. Infrastructure investing is highly illiquid and long-dated.
What is a Fund of Hedge Fund?
A fund of hedge funds (FoHF) is a portfolio of hedge funds, overseen by a manager who determines which hedge funds to invest in and how much to invest in each. In theory, this diversifies the operational risk of each hedge fund. For example, each $100 invested in a FoHF will be apportioned by the FoHF manager to several different hedge fund managers. These underlying hedge funds each pursue one strategy, such as an equity market–neutral or merger arbitrage strategy.
There are two main types of funds of hedge funds.
1. Single-strategy, multi-manager funds (also known as style-based funds of funds) invest in several funds that employ a similar strategy, such as long/short equity funds.
2. Multi-strategy, multi-manager funds invest in several funds that employ different strategies.
What is a Managed Futures Account?
This method involves the opening an individual futures trading account that is referred to as a managed futures account. This account is managed on a discretionary basis for the investor by an appropriately trained professional who is currently licensed by one or more Canadian provincial securities regulators as a commodity trading manager (CTM). CTM is the correct designation to use for a Canadian-based discretionary futures advisor. The registration designation commodity trading adviser (CTA) is the comparable licence granted by the U.S. Commodity Futures Trading Commission, and is often used interchangeably with CTM in the Canadian futures industry. This interchanging of terms occurs since a number of futures professionals hold both registrations because they often have clients/investors in both Canada and the U.S
Why does the liquidity risk of a Principal Protected Note (PPN) differ from that of a mutual fund?
A. A PPN calculates its net asset value (NAV) on a daily basis.
B. A PPN uses exchange traded option contracts.
C. A PPN sponsor may not provide a secondary market.
D. A PPN sponsor will maintain a small bid-ask spread.
C is correct.
The PPN is constructed with illiquid securities. The PPN sponsor may choose not to provide a secondary market if too many investors decide to redeem at one time. A mutual fund always will redeem units as long as the underlying securities are liquid enough.
What is the objective of a private equity fund? A. Higher relative return. B. Higher after-tax dollar return. C. Higher absolute return. D. Higher Sharpe ratio.
C is correct.
Unlike mutual funds, private equity funds are not considered to have had a successful year if fund returns are negative yet outperform the average return from a peer group. Private equity managers seek absolute returns and their traditional incentive structure, is geared towards achieving that goal.
What is the ideal profile of an investor in private equity? A. A 4 year time horizon. B. An average risk profile. C. $2 million in investible assets. D. A need for liquidity.
C is correct.
Investment minimums for private equity are high.
What is a characteristic of real estate? A. Market efficiency. B. Liquidity. C. Mobility. D. Uniqueness.
D is correct.
Each residential or commercial complex real estate parcel, inventory of single family homes or portfolio of mortgages has its own particular characteristics. Therefore, comparison with similar investments and properties is often difficult, although necessary.
Which is a drawback to holding a physical commodity? A. Roll yield risk. B. Basis risk. C. Credit risk. D. Transportation costs.
D is correct.
Physical commodity investing involves moving large quantities of the asset to and from warehouse storage areas.
What type of real estate syndication involves buying real estate zones outside of urban areas in the hope of expansion into these zones? A. Brownfield development. B. Redevelopment projects. C. Land banking. D. Blind pools.
C is correct.
Land Banking involves the purchase of raw land outside an urban area with the expectation that the urban area will expand because of economic growth in the region. This requires a significant amount of initial capital and a reserve to cover expenses for several years, until a portion of the land can be sold.
