intro/inv comm Flashcards
Compare alternative investments with traditional investments
“Traditional investments” refers to ong-only positions in stocks, bonds, and cash. “Alternative investments” refers to some types of assets such as real estate, commondities, and various collectables, as well as some specific strucutres of investment vehicles. Hedge funds and private equity funds (incluing venture capital funds) are often structured as limited partnerships; real estate investment trust (REITs) are similar to mutual funds; and ETFs can contain alternative investments as well.
Compared to traditional investments, alternative investments typically have:
- lower liquidity
- less regulation and siclosure
- higher management fees and more specialized anagement
- potential divesification benefits
- more use of leverage
- use of derivatives
- potentially higher returns
- limited and possibly biased historical returns data
- problematic historical risk measures
- unique legal and tax considerations
Describe categories of alternative investments
- Hedge funds are investment companies that use a variety of strategies and may be highly leveraged, use long and short positions, and use derivatives
- Private equity funds usually invest in the equity of private companies or companies wanting to become private, financing their assets with high levels of debt. This category also includes venture capital funds, which provide capital to companies early in their development
- Real estate as an asset calss includes residential and commercial real estate, individual mortgages, and pools of mortgages or propoerties. It includes direct investment in single properites or loans as well as indirect investment in limited partnerships, which are private securities, and mortagage-back securities and real estate investment trusts, which are publically traded
- Commodities refer to physical assets such as agricultural products, metals oil and gas, and other raw aterials used in production. Commodities market expose can provide an inflation hedge and diversification benefits
- Various types of collectibles, such as cars, wines, and art, are considered alternative investments as well
Describe potential benefits of alternative investments in the context of portfolio management
The primary motivation for adding alternative investments to a portfolio is to reduce portfolio risk based on the less-than-perfect correclation between alternative asset returns and traditional asset returns. For many alternative investments, the expertise of the manager can be an important determinant of returns.
Describe hedge funds, including as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence.
Hedge fund stategies
- event-driven strategies include merger arbitrate, distressed/restrucutring, activist shareholder and special situations
- relative value strategies seek profits from unusual pricing issues
- macro hedge strategies are “top down” strategies based on global economic trends
- equity hedge strategies are “bottom up” strategies that take long and short positions in equities and equity derivatives. Strategies include market neutral, fundamental growth, fundamental value, quantitative directional, short bias, and sector specific
In periods of financial crisis, the correlation of returns between global equities and hedge funds tends to increase, which limits hedge funds’ effectiveness as a diversifying asset class
Due diligence factors for hedge funds are investment strategy, investment process, competitive advantages, track recrod, longevity of fund, and size (assets under management). Other qualitative factors include management style, key perons risk, reputation, investor relations, growth plans, and management of systematic risk.
Describe private equity, including as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence.
Private equity strategies
Leveraged buyouts (LBOs) and venture capital are the two dominant strategies. Other strategies include developmental capital and distressed securities.
Types of LBOs include management buyouts, in which the existing management team is involved in the purchase, and management buy-ins, in which an external management team replaces the existing management.
Stages of venture capital investing include the formative stage (composed of the angel investing, seed, and early stages); the later stage (expansion); and the mezzanine stage (prepare for IPO).
Methods for exiting investments in portfolio companies include:
- trade sale (sell to a competitor or another strategic buyer)
- IPO (sell some or all shares to investors)
- recapitalization (issue portfolio company debt)
- secondary sale (sell to another private equity firm or other investors)
- or write-off/liquidation.
Private equity has some historical record of potential diversification benefits. An investor must identify top performing private equity managers to benefit from private equity.
Due diligence factos fro private equity include the manager’s experience, valuation methods used, fee structure, and drawdown procedures for committed capital.
A private equity fund is valuing a French private manufacutring company. EBITDA and market vluae for four publicily traded European companies in the same industry are shown in the folowing table (in million of euros):
(figure)
The estimated EBITDA for teh French company is 175 million. Using an average of four companies as the industry multiple, estimate the market value for the French company.
(figure)
The average multiple for thes four companies is 8x. Based on the French company’s expected EBITDA of 175 million, its estimated value is 175 million * 8 = 1,400 million or 1.4 billion
Describe real estate, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence.
Reasons to invest in real estate include potential long-term returns, income from rent payments, diversifiaction beneftis, and hedging against inflation.
Forms of real estate investing (figure)
Real estate investment categories include residental propoerties, commercial real estate, REITs, mortgage-backed securities, and timberland and farmland.
Historically, real estate returns are highly correlated with global equity returns but less correlated with global bond returns. The construction method of real estate indexes may contribute to the low correlation with bond returns.
Due diligence factors for real estate include global and national economic factors, local market conidtions, interest rates, and property-specific risks including regulations and abilites of managers. Distressed properties investing and real estate development have additional risk factors to consider.
Describe commodities, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due diligence.
The most way to invest in commodities is with derivatives. Other methods include exchange-traded funds, equitites that are directly linked to a commodity, managed futres funds, individual managed accounts, and specialized funds in specific commodity sectors.
Beyond the poetntial for higher returns and lower volatility benefits to a portfolio, commodity as an asset class may offer inflation protection. Commodities can offset inflation, especially if commodity prices are used to determin inflation indicies.
Spot prices for commodities are a function of supply and demand. Global economics production costs, and storage costs, along with value to user, all factor into prices.
Describe issues in valuing, and calculating returns on, hedge funds, private equity, real estate, and commodities
Hedge funds often invest in securities that are not actively traded and must estimate their values, and invest in securities that are illiquid relative to the size of a hedge fund’s position. Hedge funds may calculate a trading NAV that adjust for the illiquidity of these securities.
A private equity portfolio company may be valued using a market/comparables approach (multiple-based) approach, a disounted cash flow approach, or an asset-based approach.
Real estate property valuation approaches include the comparable sales approach, the income approach (multiples or discounted cash flows), and the cost approach. REITs can be valued using an income-based approach or an asset based approach
A commodity futures price is approximately equal to the spot price compounded at the risk-free rate, pkus storage costs, minus the convenience yield.
Describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds
The total fee for a** hedge fund **consists of a management fee and an incentive fee. Other fee structure specifications include hurdle rates and high water marks. Fund of funds incur an additional level of management fees. Fee calculations for both management fees and incentives fees can differ by the schedule and method of fee determination.
BJI Funds is a hedge fund with a value of $100 million at the beginning of the year (an all-time high). BJI Funds charges a 2% management fee based on assets under management at the beginning of the year and a 20% incentive fee with a 5% hard hurdle rate and uses a high water mark. Incentive fees are calculated on gains net of management fees. The ending value before fees are:
(figure)
Calculate the total fees and investor’s net return for all three years.
(figure)
The high eater mark was never an issue because this hedge fund has positive returns over each of the three years.
Describe risk management of alternative investments
Risk management of alternative investments requires understanding of the unique circumstances for each category.
- Standard deviation of returns may be misleading as a measure of risk
- Use of derivatives introduces operational, financial, counterparty, and liquidity risks
- performance for some alternative investment categories depends primarily on management expertise
- hedge funds and private equity funds are less trasparent than traditional investments
- many alterntive investments are illiquid
- indicies of historical returns and standard deviations may not be good indicators of future returns and volatility
- correlations vary across periods and are affected by events
Key items for due diligence include organization, portfolio management, operations and controls, risk management, legal review, and fund terms
Value at risk (Var) - an estimate of the size of a potential decline over a period
Sortino ratio - measures risk as downside deviation rather than standard deviation
Explain the relationship between spot prices and expected future prices in terms of contango and backwardation.
A commodity futures market is in contango if futures prices are greater than the spot price. The market is in backwardation if futures prices are less than the spot price.
Futures markets that are dominated by long hedgers (users of the commodity who buy futures to protect against price increases) tend to be in contango. Futures markets that are dominated by short hedgers (prdoucers of the commodity who short futures to protect against price decreases) tend to be in backwardation.
Describe the sources of return and risk for a comodity investment and the effect on a portolio of adding an allocation to commodities.
The return on a commodity investment includes:
- collateral yield: the return on the collateral posted to satisfy margin requirements
- price return: the gain or loss due to changes in the spot price
- roll yield: the gain or loss resulting from re-establishing position as contracts expire
Roll yield is positive if the futures market is in backwardation and negative if the market is in contango
Commoditites can provide diversification benefits to a portfolio of securities because commoditiy returns tend not to be highly positively correlated with securities returns.
Explain why a commodity index strategy is generally considered an active investment
A commidity index strategy is considered an active investment because the manager has to decide what maturities to use for the forward or futures contracts and determine when to roll them over into new contracts. Active management is also required to manage portfolio weights to match those of the benchmark index selected and to determine the best choice of securities to post as collateral and how these should be rolled over as they mature.
