Reading 50: Introduction Alternative Investments Flashcards
Define funds of funds.
These are funds that invest in a number of hedge funds, hence diversifying across hedge fund strategies, investment regions, and management styles. Funds of funds allow smaller investors access to hedge funds in which they may not be able to invest directly.
Characterize hedge funds.
Hedge funds are designed to give the hedge fund manager more choices than the traditional mutual fund manager has. Hedge funds have the ability to invest in any asset that can increase in value over time, as long as the asset involves legal activity and the hedge fund manager discloses the investment strategy.
Differentiate between a hurdle rate and a high-water mark provision.
A hurdle rate defines the minimum return threshold that the fund must earn before any incentive fee is paid.
A high-water mark refers to the highest value, net of fees, that the fund has reached.
List the key due diligence points when investing in hedge funds.
Investment strategy and process
Competitive advantage
Track record
Size and longevity
Management style and key-person risk
Reputation and investor relations
Plans for growth
Methodology used for return calculations
Systems for risk management
Identify the challenges of alternative investments.
Obtaining reliable measures of risk and return
Identifying the appropriate allocation
Selecting portfolio managers
Describe the 3 sources of return on a commodity futures contract.
- Roll yield: The difference between the spot price of a commodity and the futures price, or the difference between the futures prices of contracts expiring at different dates.
- Collateral yield: The interest earned on the collateral (margin) deposited to enter into the futures contract.
- Spot prices: These are influenced by current supply and demand.
Why do alternative investments generally have higher returns?
Tax advantages
Portfolio managers’ ability to exploit mispricings
Return premiums for illiquidity
Significant use of leverage
Give the reasons investors generally invest in real estate.
It can offer competitive long-term total returns, driven by income generation and capital appreciation.
Multiple-year leases with fixed rents for some property types provide stable cash flow that is relatively immune to economic shocks.
It may offer diversification benefits due to its less than perfect positive correlation with other asset classes.
It serves as an inflation hedge if rents can be adjusted quickly for inflation.
List the categories of the underlying assets of infrastructure investments.
Economic or social infrastructure assets
Brownfield or greenfield investments
Geographical location
Explain the risk management issues of alternative investments.
Investments in certain types of alternative investments require long holding periods.
Hedge funds and private equity funds are less transparent than other investments, as they may consider their investment strategies to be proprietary information.
Investments in many alternative investments are relatively illiquid.
Explain the common exit strategies.
Trade sale: This occurs when a company is sold to a strategic buyer, either through an auction or through a private negotiation.
Initial public offering (IPO): This involves taking the private company public.
Recapitalization: This is a very popular strategy when interest rates are low.
Identify the critical aspects of a hedge fund.
Hedge funds are aggressively managed portfolios of investments.
They aim to generate high returns (either on an absolute basis or relative to a specified benchmark).
They are set up as private investment partnerships, where the fund is the general partner (GP) and the investors are limited partners (LPs).
Hedge funds usually impose restrictions on redemptions.
List the 4 broad categories of hedge fund strategies and give examples of each.
Event-driven strategies: merger arbitrage; distress/restructuring; activist; and special situations
Relative value strategies: fixed-income convertible arbitrage; fixed-income asset-backed; fixed-income general; volatility; and multistrategy
Macro strategies: taking positions in broad markets currencies, commodities, etc.
Equity hedge strategies: market neutral; fundamental growth/value; quantitative directional; short bias; and sector specific
Give the formula used to calculate the price of a futures contract on a commodity.
Futures price = Spot price × (1 + Risk-free short-term rate) + Storage costs − Convenience yield
Identify the approaches typically used to value companies in the private equity industry.
Market or comparables approach: This is a relative valuation technique that uses equity multiples of different measures to value a company.
Discounted cash flow (DCF) approach: This is an absolute valuation technique in which the value of a company is determined as the present value of its expected future cash flows.
Asset-based approach: This approach values the equity of a company as the total value of its assets minus the value of its liabilities.
List the categories of alternative investments.
Hedge funds
Private equity funds
Real estate
Commodities
Infrastructure
Tangible and intangible assets
List the strategies used in private equity (PE) investments.
Leveraged buyouts (LBOs)
Venture capital (VC)
Development capital
Distressed investing
Differentiate between self-selection bias and survivorship bias.
Self-selection bias: Since disclosure of performance data to hedge fund indexes is voluntary, fund managers tend to reveal their performance only if it is impressive.
Survivorship bias: This occurs due to the fact that unsuccessful funds tend to go out of business and only well-performing funds are willing to disclose their historical performance for inclusion in hedge fund indexes.
What are the due diligence factors of risk management?
Fund policies and limits
Risk management policy
Portfolio risk and key risk factors
Leverage and currency risks, constraints, and hedging
Name the types of commodity investment vehicles.
Exchange-traded funds (ETFs)
Common stock of companies exposed to a particular commodity
Managed futures funds
Individual managed accounts
Specialized funds
Identify the advantages of investing in infrastructure.
Enables investors to add a steady income stream to their portfolios.
Enables investors to further diversify their portfolios, as infrastructure assets exhibit low correlation with other investments.
Enables investors to gain some inflation protection.
Identify the downside risk measures.
Value at risk (VaR): This estimates the minimum amount of loss expected over a given time period at a given probability.
Shortfall or safety-first measures: These measure the probability that the value of the portfolio will fall below a minimum acceptable level over a given period. These measures use the standard deviation, so they underestimate risk for a negatively skewed distribution.
Sortino ratio: This measure of downside risk uses downside deviation as opposed to standard deviation as a measure of risk.
Describe leveraged buyouts (LBOs).
They refer to acquisitions of public companies or established private companies, where debt is used to finance a significant proportion of the acquisition. Cash flows from the acquired company are the primary source of debt service payments, while assets of the acquired company serve as collateral for the debt.
List the due diligence factors of portfolio management.
Investment process
Target market and asset types and strategies
Sourcing of investments
Role of operating partners
Underwriting
Environmental and engineering review process
Integration of asset management, acquisitions, and dispositions
Disposition process, including how initiated and executed
