Chapter 13 - Non-Conventional Asset Classes and Their Structures Flashcards
What are alternative assets?
Asset classes different from the traditional 3 broad asset classes of equities, bonds, and cash.
What are the 3 main reasons to include alternative investments in a portfolio?
- Increase returns without increasing risk (at least not too much)
- Decrease risk without losing returns
- Increase the portfolio’s absolute return, making it more resistant to capital erosion during market downturns
They essentially allow the investor to move to a higher efficient frontier.
What are hedge funds?
Lightly regulated pools of capital with managers that have great flexibility in their investment strategies, through the use of short positions, leverage, derivatives, arbitrage, and investment in almost any situation in the market.
What are the two major categories of commodities?
Those that are mainly used for consumption and those mainly used for investment purposes.
What are the advantages of commodities in a portfolio?
Commodities can have high returns and tend to produce relatively high returns when traditional assets perform poorly. They also have low correlations to traditional asset classes but positive correlation to inflation, supporting the idea that they can exhibit real inflation-adjusted returns.
What are the 3 segments of the real estate market?
Commercial, industrial, residential
When does real estate as an asset become a liquid investment?
When it is securitized. This is done by reselling shares in a pool of real estate assets to investors, such as with a REIT.
How is real estate impacted by inflation?
It’s sensitive to inflation, therefore it tends to protect a portfolio from its effects.
What are the inefficiencies of real estate?
- Fragmentation, there is no central trading market.
- Limited number of buyers.
- Legal and contractual constraints affect values.
- Need for property management.
What is mortgage syndication?
When investors pool their funds together to create a single mortgage. They hold mortgages secured by properties, but generally do not have the quality of covenants that are typical with mortgages held in mortgage mutual funds (often holding second and third mortgages).
What are the 4 general categories of infrastructure assets?
- Regulated assets
- Transportation assets
- Communication assets
- Social assets
How does infrastructure credit complement a fixed income portfolio?
Can offer higher yields, longer duration, and credit diversification.
What does it mean that the loans used in infrastructure project finance are “nonrecourse”?
The only claim the creditor has is on the cash flows produced by the infrastructure asset and not the asset itself.
How are private market investments structured?
As limited partnerships, which allows investments to be marketed through an offering memorandum.
How are private investment funds structured?
Can be open-ended or closed-ended. If closed-ended, they will solicit investments over a period, then close to new investors/assets once a threshold level of assets is attained.
What are the methods of private equity financing?
- Buyouts (leveraged or management)
- Growth capital
- Turnaround
- Venture capital (early or late stage)
What are the methods of private debt financing?
- Senior credit
- Subordinated credit
- Unitranche credit
- Distressed credit
- Credit opportunities
- Specialty finance
What is a leveraged buyout?
Purchasing a public/private firm and recapitalizing its debt. Often a company with weak growth prospects but strong cash flow. Up to 90% of the purchase amount is financed with debt, and debt is paid down using the strong cash flow and sale of company assets.
What is a management buyout?
Private equity firm purchases businesses from existing management.
When is growth capital financing used?
For established companies seeking liquidity to improve their operations and enter new markets.
What is turnaround financing?
Investment in underperforming or out-of-favour companies in financial need or undergoing restructuring?
What is another term for subordinated credit?
Mezzanine lending
Which type of companies typically use subordinated credit?
Used to finance companies often in the transitionary or expansionary stages
What is unitranche credit?
Hybrid structure that combines senior and subordinated debt into one instrument with a blended rate.
Common for interest and repayment of capital to happen at the end of the loan in the form of a bullet payment.
What is distressed credit?
Distressed debt funds purchase the debt obligations of firms either in bankruptcy or who will soon enter bankruptcy under the belief that the debt obligations are mispriced and the debt value will increase after restructuring.
What are the 2 strategies used by distressed debt fund managers?
- Non-controlling - minority debt positions in several companies
- Active - purchase enough debt obligations of a firm to be able to influence the restructuring process
What is a ‘workout in private credit’?
The act of influencing the restructuring process by working with a debtor to improve their financial position. The creditors alter the terms of original debt obligations, often lowering interest service costs or forgiving a portion of the loan in exchange for an increased claim on assets.
What are the different specialty finance areas?
- Royalties (oil & gas, music, pharmaceutical)
- Distressed debt
- Trade finance
How do private equity funds have an advantage over mutual funds in security selection?
Private equity funds often own large, controlling stakes in companies. Private credit funds generally originate their own loans, which are held by one or few lenders. Mutual funds often hold the same underlying investments as their peer group.
What does it mean that private equity funds have absolute return goals?
A year in which a fund has outperformed a peer group but has negative returns would be considered an unsuccessful year.
Why can the illiquidity of private equity funds be considered an advantage?
If there is a long time horizon, such as for an institutional investor, the illiquidity premium is a benefit.
Why do high management fees and performance fees create risk bias in private equity funds?
Managers may tend to take higher risk to clear the hurdle fee to generate worthwhile returns for LPs.
What is meant by “blind pool” investing when it comes to private equity?
The investor is not buying a specified group of assets, but rather the private market manager’s skill at identifying and managing these assets to profitability.
What is the J-curve effect?
Once invested in a private equity fund, the capital will typically be held at cost with no returns credited to the investment until there is a liquidity event. Since management fees could be charged upfront, the private equity investment would show negative returns until the fund starts to realize some positive returns.
Which private market funds are less impacted by the J-curve effect?
Private credit funds that earn most of their returns through regular coupons.
What types of costs are entailed with investing in collectibles?
Auction fees, appraisal costs, collection maintenance, insurance, storage, and transportation.
What are some risks associated with collectibles?
- Illiquid market
- High costs
- Pure capital gains
- Risk of fraud/forgery
Why can an illiquid market for collectibles be a benefit to investors?
There’s the potential to exploit inefficiencies.
What are the two general categories of digital assets?
Crypto assets and non-crypto assets
What are the two types of crypto assets?
Bitcoins and altcoins. Altcoins are modeled on bitcoins but are different in some ways, the largest being ether (ETH)
What is the SEC definition of a digital asset?
“An asset that is issued and transferred using distributed ledger or blockchain technology, including but not limited to, virtual currencies, coins and tokens.”
What is blockchain?
A decentralized public transaction ledger on which all transactions are recorded.
How does bitcoin differ from Bitcoin?
Capital B represents the protocol layer (the Bitcoin blockchain) and lower-case b refers to the bitcoin as a financial value.
What does a bitcoin wallet contain, how does this allow for storage/transfer of value?
Contains a public key and a private key, which work together to allow the owner to initiate and digitally sign transactions. The private key is essentially the secret password. Both keys provide proof of authorization to proceed with transactions, which are irreversible.
What does it mean that bitcoin is a “deflationary currency”?
The US dollar for example is an inflationary (fiat) currency. More supply is created over time, so the nominal price of goods rises. Bitcoin is a deflationary currency, there is a limited supply so each unit of currency buys you more, not less, over time. It retains its value, unlike our national fiat currencies.
What is a fiat currency?
A national currency not pegged to a commodity.
What is Ethereum?
Ethereum is a ledger technology that companies are using to build new programs (smart contracts). Ethereum operates on far more robust blockchain technology than Bitcoin, allowing for the building of decentralized applications on top of it.
How does ether differ from bitcoin?
Ether (Ethereum’s native currency) has a primary purpose of facilitating and monetizing the operation of Ethereum contracts. This contrasts with bitcoin which establishes itself as an alternative payments system.
What is litecoin?
Cryptocurrency related to bitcoin. Transaction speed improvements have been made, making it more efficient as an electronic payment system than Bitcoin.
What are security tokens?
Similar to securities that trade on stock markets, except they reside in a digital format. Often promise equity (ownership) or a dividend payout to holders. They derive their value from an external tradable asset, such as a stock or real estate.
How are security tokens generally offered to investors?
Through Security Token Offerings (STOs).
What are utility tokens?
Provide access to a future product or service, often used in the creation of Initial Coin Offerings (ICOs) to fund startups where investors get tokens in exchange for the crypto/fiat currency investment they are making in the startup.
What are NFTs?
Non-fungible tokens represent a digital recording of ownership of a token, which can then be transferred to a digital wallet. Also uses blockchain. An NFT can represent a piece of art, a music album, sports memorabilia, or other type of digital files.
How do NFTs differ from cryptocurrency?
While they both use blockchain, each NFT has a unique value and cannot be exchanged for another of equal value. NFTs are essentially digital bragging rights for collectors’ items using a unique digital signature that serves as proof of ownershup.
What is decentralized finance?
It’s a form of finance that does not rely on financial intermediaries and is built on blockchain or distributed ledger technologies. The code is transparent and the platforms are global, they’re open for anyone to use, rather than going through an intermediary like a bank or brokerage.
Why are non-bank crypto companies offering to pay cryptocurrency owners higher yields than traditional bank deposits?
They are earning money by lending out bitcoin to various types of financial participants (including institutional). The higher yield then represents the additional risk. In addition to the overall risk of owning crypto, earnings are paid in cryptocurrencies which can fluctuate significantly in value. And no CDIC coverage.
What are prediction markets?
Built on Ethereum blockchain and enable users to stake digital assets on the outcomes of real-world events.
What are the 2 segments that the hedge fund market can be split into?
- Funds targeted toward high-net-worth and institutional investors.
- Funds and other hedge fund-related products targeted toward broader individual investors (the “retail” market)
What are the only type of investors that can invest in hedge funds in Canada?
Accredited investors. (Institutions or people with high net worth/income)
How are hedge funds typically structured?
As limited partnerships or trusts, and issued by way of private placement through an offering memorandum instead of a prospectus.
What is the typical lock-up period for a hedge fund?
Often 1-2 years, during which initial investments cannot be redeemed.
When can a hedge fund investor typically redeem their funds?
After a lock-up period (often 1-2 years) and on specific liquidity dates, which are specified dates on which hedge fund investors may redeem their units (often quarterly or annually). 30 days notice is often required for redemptions.
How could/should hedge funds be treated in an asset allocation framework?
Either as a separate asset class or integrated within existing asset classes in the portfolio.
What are the 3 general hedge fund equity categories?
- Relative value (equity market-neutral)
- Event-driven (merger arbitrage)
- Directional (long/short equity, global macro, emerging mkts, managed futures, dedicated long or short bias)
What are the 3 general fixed income hedge fund categories?
- Relative value (convertible arbitrage, fixed income arbitrage)
- Event-driven (distressed securities and high-yield bonds)
- Directional (global macro, emerging markets, managed futures)
When did liquid alts become available in Canada?
Since January 2019
What have studies found when comparing hedge funds with liquid alts?
Though liquid alts do underperform hedge funds slightly, they help with downside protection just as much as hedge funds and help investors achieve better diversification than standard mutual funds.
What are the 6 main alternative investment strategies?
- Managed futures
- Relative value
- Equity long/short
- Event-driven
- Tactical trading/macro
- Multi-strategy
What are the 2 main ways commodities can be traded?
By futures and futures options through one of two means:
1. Standard managed futures account
2. Commodity trading account
How does a managed futures account work?
An individual futures trading account is opened and managed on a discretionary basis by a CTM (commodity trading manager) (or commodity trading adviser in the US). Typically must be exempt/accredited under prov securities regulations to open one.
What id a commodity trading account?
Opened by individual investor to trade and manage their commodity futures portfolios themselves without a CTM. Similar to a regular brokerage account.
Why is there so much risk with leveraged commodity futures?
On a fully leveraged basis, an investor can potentially lose the entire margin deposit (and more) with just a 2-5% price movement in the wrong direction.
How can one invest in commodity futures without the risk?
Invest in commodity ETFs that replicate a broad-based commodity index, or a commodity mutual fund.
What are the 3 major types of commodity-related ETFs?
- Index ETFs
- Commodity ETFs
- Leveraged ETFs
How could a commodity-related index ETF be structured?
May consist of a basket of stocks in a commodity-related field or may hold a basket of physical commodities.
How do commodity ETFs provide direct exposure to the underlying asset’s price movements?
Through either…
1. Physical ownership of commodities (stores of resources)
2. Synthetic replication (futures, swaps, options)
What types of returns are leveraged ETFs structured to provide?
1.5 to 3 times the rate of return of an unleveraged reference portfolio
What are inverse ETFs?
Leveraged ETFs designed to provide rates of return opposite to current market returns.
What is roll yield risk with futures-based ETFs?
If a front month futures contract is trading at a premium to the spot market price, the roll yield. The front month contract must equal the spot price when the contract expires, so it will incur the loss of the roll yield, unless the market factors in higher prices before the contract has expired.
What factors do a commodity producer’s profitability rely on?
The commodity’s market price as well as different operational variables (quantities produced, cost of production, selling price)
What is a commodity firm’s product price hedging strategy?
The decision to sell future production at prevailing market prices of employ a hedge strategy to lock in a price on some or all of future sales volume.
Which commodity producers would be considered more volatile than others?
Ones that do not employ hedging strategies are more volatile.
What is a tactical hedging strategy for a commodity producer?
When a commodity producer hedges part of their future production or only for a certain period of time.
What is a “pure play” for a commodity producing company?
Company with operations whose revenues are 100% dependent on the production of the raw commodity itself. This is rare.
What is vertical integration for a commodity producer?
A company that derives its revenues from different areas in the commodity production chain (extraction, refining, storage, sales, etc.)
How are real estate investments sold under prospectus exemptions typically offered?
Through the form of limited partnerships. This allows for a flow-through structure of interest and other income directly to the limited partners.
How are mortgage syndications generally structure as?
As mortgage investment corporations. Income flows through to investors to be taxed in their hands, and can receive distributions monthly (if structured as such).
What are the most common types of real estate syndications?
- Land banking
- Brownfield development
- Redevelopment projects
- Purchase of mature properties
- Purchase of distressed properties / mortgages in default
- Mortgage syndications
- Mortgage fund on a specific project
- Blind pools
What is land banking?
Usually involves the purchase of a tract of raw land outside of an urban area with the expectation of economic growth. Goal is capital appreciation and it can be a long time horizon (often 5-20 years).
What is a brownfield development?
Redevelopment of an abandoned or underused commercial/industrial property (generally in an urban community).
What is a blind pool?
Investors are presented with info about the general type of real estate/real estate securities that the pool mgmt tends to invest in, but exact investments are unknown when the investor commits to the pool.
When do real estate prices generally perform well?
Generally offer good returns when inflation is increasing and inflationary expectations are high. May decline in a deflationary environment.
How do real estate equity securities provide additional diversification in a portfolio?
Positive correlation with inflation, unlike fixed income and non-resource equities, which tend to be negatively correlated with inflation.
What is a collateralized mortgage obligation (CMO)?
Mortgage-backed bond that separates mortgage pools into staggered maturity groups (tranches) that reallocate the interest and principal payments. Each tranche is sold as a separate security and has a different claim on the underlying cash flow (those that receive capital first and last).
What is a stripped MBS?
Divides the cash flows from the underlying mortgage security into two or more new securities. Strips can be partially stripped (receiving principal and interest) or completely stripped (interest only or principal only).
How do REITS work?
Consolidate the capital of a large number of investors to invest in and manage a diversified real estate portfolio. Investors participate by buying units in the trust.
Are REITS more correlated to equities or bonds?
Typically more correlated to equities than bonds due to their sensitivity to macroeconomic factors and overall economic health.
How are Canadian REITs taxed?
Pre-tax income flows through to investors and is taxed in their hands.
What is co-investing as a form of direct investing?
An investor partners directly with a private market firm. (They invest directly in a company controlled by the firm.)
What is the difference between direct funds and direct investing?
Through direct funds, investors join a direct fund as limited partners. The fund invests in 10-30 transactions and offers better diversification with lower capital commitments.
How do fund of funds differ from direct funds?
Private equity fund that invests in up to 20 funds with each fund itself in 10-30 direct investments.
What are publicly traded private equities?
Publicly traded companies that raise capital through public equity markets with the intent to then invest in private market transactions.
What are closed-end funds?
Raise capital through an offering, then doesn’t take on new capital. Shares are listed for trading on a stock exchange.
What are evergreen funds?
Type of private market fund that tends to have a lower management fee, and often use a reinvestment cycle where every 4/5 years (and upon valuation) investors can exit without penalties (and the fund manager can raise new capital).
What are the ways in which cryptocurrency can be acquired?
Peer-to-peer transactions (often completed by registered money service businesses)
Cryptocurrency exchanges
Cryptocurrency ATMs
Traditional brokerage accounts
Digital assets investment products
What was the first crypto-only CIRO-registered investment dealer?
Coinsquare
