Chapter 20: Others managed products

Question 1

How can alternative strategies be categorized?

Answer 1

both by type of strategy and by the type of structure

Question 2

When generally alternative can be found?

Answer 2

in exempt alternative funds (hedge fund), alternative mutual funds (liquitt alts), exchange-traded funds (ETFs), and closed-end funds.

Question 3

what are alternative investments?

Answer 3

are asset classes that are different from the traditional three broad asset classes of equities, bonds, and cash.

Question 4

How are alternative assets categorized?

Answer 4

1. Alternative strategy funds
2. alternative assets
3. private equity

Question 5

what are tithe different between alternative strategy funds compare to conventional mutual funds?

Answer 5

• they have fewer or no regulatory restrictions on the use of short selling, leverage, and derivatives.
• they also have greater flexibility to invest in illiquid investments
• managers are able to generate risk and return results that can be substantially different from those found in conventional funds (even if they use the same stocks and bonds)

Question 6

What are the three general group of alternative strategy?

Answer 6

1. Relative value: Relative value strategies attempt to profit by exploiting discrepancies in the pricing of related stocks, bonds, or derivatives
2. Event-driven: Event-driven strategies maintain positions in companies currently or prospectively involved in corporate transactions including mergers, consolidations, restructurings, tender offers, shareholder buybacks, and other capital adjustments
3. Directional: Directional strategies attempt to profit from anticipated movements in the prices of assets such as bonds, equities, foreign currencies, and commodities

Question 7

What are the common types of alternative assets?

Answer 7

1. Commodities (commodities exhibit low or negative correlation to traditional asset classes and have a positive correlation with inflation -> produce inflation-adjusted returns)
2. Real estate
3. Collectibles (objects that are desirable to individuals)
4. Infrastructure (refers to such projects as roads, ports, airports, and water works)
5. Natural resources (farmland and timberland, timberland is more popular now).

Question 8

Why invest in alternative investment?

Answer 8

1. To diversify the portfolios
2. To add alpha
3. Tot increase the portfolio’s absolute return nature.

Question 9

What is the benefits of diversifying the portfolios?

Answer 9

• Reduced volatility through a more stable net asset value (NAV) for the overall portfolio
• Downside protection in periods of market stress through reduced drawdowns
• Greater allowance for leverage, which can offer higher expected returns

Question 10

What is alpha?

Answer 10

alpha is a measure of the manager’s performance. If it is positive, the manager has produced more return than was predicted by his or her beta calculation, which indicates that the manager has added value to the portfolio. The greater the alpha, the more value the manager added, and therefore the better they have performed. On the other hand, an alpha value of zero indicates the manager has achieved only normal performance, meaning that they have added nothing to the portfolio’s value beyond its beta. If alpha is negative, the manager has underperformed for the level of risk taken on.

Question 11

How alternative investment have higher alpha?

Answer 11

• Alternative investment funds can attract highly skilled managers because of their pay-for-performance compensation structure.
• As well, these funds are able to use strategies like short selling, leverage, and products such as derivatives that are limited or unavailable to conventional mutual fund managers.
• Additionally, alternative managers generally have greater flexibility with respect to investing in less liquid securities, such as private equity, real estate and distressed securities
• > Alternative managers are generally able to produce higher risk-adjusted returns relative to conventional managers.
• Also, many alternative investments target absolute returns, which means they aim to produce positive returns regardless of market direction.

Question 12

What can explain between 40% and 90% of a portfolio’s volatility?

Answer 12

asset allocation, rather than security selection

Question 13

what is efficient frontier?

Answer 13

• the curve that reflects the most efficient portfolios for all levels of risk. All points below the efficient frontier are inefficient in the sense that by moving a portfolio up to the frontier, either risk can be reduced for a similar return potential or return potential can be increased for a similar level of risk
• The efficient frontier is normally shown on a graph and is composed of combinations of assets that combine the lowest level of risk with the highest expected return at that level of risk. Standard deviation, representing risk levels, is measured along the x-axis. Expected portfolio return is measured along the y-axis

Question 14

How alternative investment can create new efficient frontier?

Answer 14

By adding an asset class with a low correlation to stocks and bonds

Question 15

what is the empirical evidence of variance between alternative strategy and traditional investment?

Answer 15

they have generally outperformed traditional investments when traditional investments were performing poorly, such as during the 2004 – 2012 period. Conversely, hedge funds performed relatively poorly when traditional investments were performing very well during the 2013 – 2019 period. also hedge funds performed very well, relatively speaking, during times of extreme stress in the traditional markets

Question 16

What is the most frequently used measure of investment risk of alternative investment?

Answer 16

is volatility as measured by standard deviation. It is used in two portfolio management applications:

1. Deciding on portfolio allocation to alternative investments utilizing an efficient frontier, and
2. When calculating risk-adjusted return measures such as the Sharpe ratio

Question 17

What is the second most frequently used measure of investment risk of alternative investment?

Answer 17

is the fund’s drawdown amount. The drawdown amount is essentially the maximum percentage decline in the alternative fund’s NAV over a specified time period

Question 18

What are the ALTERNATIVE STRATEGY RISK DRIVERS?

Answer 18

1. first-order risk (or directional risk)
2. second-order risk (such as liquidity risk, default risk, and leverage risk)
3. operational risk (or business risk)

Question 19

What is first-order risk?

Answer 19

relate to the exposure to changes in the general direction of equity, fixed income, currency, and commodity markets. The source of risk is the market itself, and the risk is systematic, meaning that it 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 an alternative strategy fund manager’s views about the direction of different markets, interest rates, commodity prices, and currencies

Question 20

What is second-order risk?

Answer 20

Second-order risks include liquidity, leverage, deal break, default, counterparty, trading, concentration, pricing model, and trading model risks. Unlike first-order risk, these risks are not related to the market, but to other aspects of trading, such as dealing, implementing arbitrage structures, and pricing illiquid or infrequently valued securities

Question 21

What are the types of risk in second-order risk?

Answer 21

1. liquidity risk
2. Leverage risk
3. deal breakage risk (The risk of loss from the failure of two companies to complete an announced merger)
4. default risk
5. Counterparty risk (The risk that the counterparty to an OTC agreement will not fulfill its obligations)
6. trading risk (The risk of receiving a poor fill price based on unexpected delays in execution)
7. concentration risk
8. pricing model risk (The risk that the output of a pricing model is incorrect because the assumptions on which the model is based are incorrect)
9. trading model risk (The risk of loss related to the failure of systematic trading models in the current market environment)

Question 22

What is operational risk?

Answer 22

elates to the alternative strategy fund as a business entity. It stems from the fact that alternative strategy funds can be 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 or managers. However, they may lack the organizational depth, managerial talent, and strategic planning capabilities necessary to ensure growth, or even survival. For most alternative strategy funds, operational risk stems from potential system failures, as well as faulty settlement, reporting, and accounting procedures. Operational risk is significant and must be addressed through due diligence

Question 23

How can Canadian investors gain access to alternative strategies?

Answer 23

hedge funds, liquid alternatives, ETFs and closed-end funds.

Question 24

What is hedge fund (EXEMPT MARKET ALTERNATIVE FUNDS)?

Answer 24

are lightly regulated pools of capital with managers that have great flexibility in their investment strategies. They can take large short positions, use leverage and derivatives for speculation, perform arbitrage transactions…
(lternative investment strategies under modified mutual fund regulations does not impact alternative investment products offered under existing regulatory exemptions for exempt/accredited investors and the minimum initial investment exemption)

Question 25

WHO CAN INVEST IN HEDGE FUNDS?

Answer 25

• Minimum investment exemption (NI 45-106 sets this minimum at $150,000 across all Canada)
• Accredited investor exemption (institutional net asset >5mil$, individual 1. Financial assets >1mil$ or 2. net income >200k or family income >300k or 3. net asset >5miil$)
• Offering memorandum exemption (An eligible investor has a lower financial threshold than an accredited investor but requires a confirmation of suitability from an eligibility advisor who is a registered investment dealer)

Question 26

What is incentive fee?

Answer 26

• Incentive fees are usually calculated after management fees and expenses are deducted, rather than on the gross return earned by the manager.
• designed to attract top money managers and then to provide them with an incentive to perform well.

Question 27

What are the measurements off calculation for incentive fees?

Answer 27

1. High-water mark (ensures that a fund manager is paid an incentive fee only on net new profits)
2. Hurdle rate (the rate a hedge fund must earn before its manager is paid an incentive fee)

Question 28

How is hedge funds liquidity?

Answer 28

the degree of liquidity differs with the nature of the alternative strategy being employed by the hedge fund manager, all hedge funds are less liquid than say mutual funds.
some funds have monthly subscriptions and quarterly redemptions with 30 days’ notice required before redemption
and some have an initial lockup period (one to two years is common) during which initial investments cannot be redeemed

Question 29

What is hedge fund’s transparency(detail, frequency, time between report day and communication with investor date)?

Answer 29

information regarding fund holdings and activity might only be reported semi-annually, and often with a 90-day delay. For exempt funds, information regarding the fund’s degree of transparency is provided in the hedge fund’s offering memorandum (which is not subject to regulatory restrictions

Question 30

What are the hedge fund’s investor protection?

Answer 30

Rights of withdrawal permit a conventional mutual fund investor to cancel their investment without penalty within a two-business day period after they have received confirmation of their investment. This right also applies to investments in alternative mutual funds.
the right of rescission gives investors the right to rescind their purchase if the Fund Facts or simplified prospectus contains misrepresentations. This right applies to both conventual and alternative mutual funds but only applies to hedge funds if stipulated in the offering memorandum

Question 31

What are alternative mutual funds (liquid alts)?

Answer 31

• Greater usage of derivatives, leverage, and short selling than conventional mutual funds as well as a greater single issuer concentration. The alternative mutual funds still have limitations to each of these and therefore cannot use these to the extent they could be used by hedge funds. As well, alternative mutual funds have the same restrictions on investing in illiquid investments as conventional mutual funds

Question 32

What are the benefits that Alternative mutual funds provide retail investors?

Answer 32

Access to investment strategies that were previously largely available only to exempt investors
• The goal of earning absolute returns during all phases of a market cycle
• The transparency, daily liquidity, and investor protection rights that are associated with conventional mutual funds (despite the ability of alternative funds to engage in riskier and potentially higher return strategies)
• Considerably lower minimum investment required in comparison to hedge funds
• Low fees, generally, in comparison to hedge funds

Question 33

What is FUNDS OF HEDGE (OR LIQUID ALTS) FUNDS?

Answer 33

Both hedge funds and liquid alts are able to invest up to 100% of their net assets in other mutual funds (including alternative mutual funds), thus creating a fund-of-funds structure (FoHF)

Question 34

What are the two main types of FoHF?

Answer 34

Single-strategy, multi-manager funds invest in several funds that employ a similar strategy, such as long or short equity funds and convertible arbitrage funds.
• Multi-strategy, multi-manager funds invest in several funds that employ different strategies.

Question 35

what are the advantages of FoHF?

Answer 35

1. Due diligence (conduct thorough due diligence and ongoing risk monitoring for hedge funds)
2. Reduce volatility (lower volatility and risk than that of its underlying funds)
3. Professional management
4. Access to hedge funds (provide access to hedge funds for investors who would otherwise be shut out)
5. Ability to diversify with a smaller investment (increase access by smaller investors to hedge funds)
6. Manager and business risk control (some hedge funds pursue riskier investment strategies, they may be more likely to experience problems that could lead them to terminate the fund. This so-called blowup risk can be diversified away through an FoHF)

Question 36

what are the disadvantages of FoHF?

Answer 36

1. Additional cost
2. no guarantees of positive returns
3. low or no strategy diversification (Some may not provide adequate diversification, depending on
   the objectives sought by the investor. Others may dilute returns and provide more diversification than the investor needs)
4. additional sources of leverage
5. Low or no strategy diversification (Some FoHFs are strategy-specific and invest only in one type of hedge fund, such as long/short equity or convertible arbitrage)

Question 37

How is alternative strategy in some ETFs (liquid alternative ETFs)?

Answer 37

• regulated under NI 81-102
• allowed a certain degree of flexibility with respect to derivatives and leverage (but not short selling of non- derivative securities)
• intra-day on an exchange