Portfolio Management 5- Characteristics of Alternative Investments Flashcards
What are Alternative Investments?
Almost any asset that is not traditional in nature, from real estate and commodities to rare coins and artwork. They can be made directly or indirectly.
Investments in shares of stock, bonds, and cash equivalents have historically been identified as being _________
traditional in nature
When investing in alternative investments what should the correlation of these investments be in relation to traditional investments such as stocks, bonds, etc in order to have diversification?
Negative
Why are investors attracted to alternative investments?
Because of their diversification benefits
Why are stock, bonds, and cash equivalents considered traditional investments?
mostly because they have traded in relatively highly liquid markets for more than a
century.
Name three challenges of forming a portfolio with alternative investments?
Obtaining reliable measures of risk and return.
* Identifying the appropriate allocation.
* Selecting portfolio managers.
Why do most alternative investments exhibit higher returns than traditional investments?
Tax advantages (e.g., for REITs).
* Portfolio managers’ ability to exploit mispricings.
* Return premiums for illiquidity.
* Significant use of leverage
What should financial analysts consider when evaluating the history of alternative investments?
Reported returns and standard deviations are averages, which may not be representative of
returns and standard deviations for subperiods within the reported period, or for future periods.
* The volatility of returns of alternative investments, as well as the correlation of returns with
those of traditional asset classes, may be underestimated. This results from the fact that returns
on many alternative investments (e.g., direct real estate and private equity) are computed using
estimated values rather than actual market prices.
* Hedge fund indexes may be inherently biased upward due to self-selection bias, backfill bias,
and survivorship bias.
What are three biases hedge funds may become susceptible to that make their investments appear to have better performance?
1) Self-selection bias
2) Backfill bias
3) Survivorship bias
What are those who invest in alternative investments seeking?
Absolute returns throughout the economic cycle
Relative returns against a benchmark
How do investors in alternative investors find absolute returns throughout the economic cycle relative returns or relative returns against a benchmark?
by finding assets that have low correlations with
traditional securities. These funds give managers the flexibility to use derivatives and leverage, to make investments in illiquid assets, and to take short positions.
Roberto Seger, a high net worth investor with a $2.5 million equity portfolio, is considering the purchase
of a building that is currently under lease to the U.S. federal government. The lease is transferable and
expires in 15 years. The price of the building is $1.2 million, and the annual lease payments are $150,000
per year for the next 5 years, at which time the terms can be renegotiated, but the government has the
option to cancel the lease after 5 years. Seger estimates the correlation coefficient between the building
and his equity portfolio to be 0.14.
Identify two benefits that Franks can reasonably expect if he purchases this building and two issues that
should concern him in the context of portfolio management.
Clearly, Seger will benefit from the income generated by the property, at least for the first 5 years. The
annualized internal rate of return (IRR) of the investment is approximately 9% if the payments extend to
the 15-year mark. Diversification also appears to be a key benefit with a correlation of only 0.14. The
first concern Seger should have is the accuracy of the correlation data on which his estimate was based.
Although buildings leased to governments most likely have low correlations with equity securities, the
precise diversification benefit is less easily measured. A second concern should be the manner in which
this building fits into Seger’s strategic asset allocation. The alternative investment allocation would be
approximately 33%, and this is not likely to be optimal. The ability of the government to cancel the lease
is another concern, but not one that would likely prevent Seger from making the investment.
What is a self-selection bias?
What is a backfill bias?
What is a survivorship bias?
