Reading 60 LOS's

Question 1

LOS 60a: Compare alternative investments with traditional investments

Answer 1

Alternative investments differ from traditional investments with repect to 1) the types of assets and securities invested in and 2) the structure of the investment vehicles in which these assets are held.

• Alternative investments, as an asset class, include asset such as real estate and commodities
• Investments can be made through special vehicles such as private equity funds, hedge funds, and exchange traded funds

Investments in these special vehicles are generall characterized by:

• High fees
• large size of investments
• low diversification of managers and investments within the alternative investment portfolio
• high use of leverage
• restrictions on redemptions

Other characteristics that are common to many alternative investments are:

• Illiquidity of underlying investments
• narrow manager specialization
• low correlation with traditional investments
• low level of regulation and less transparency
• limited and potentially problematic historical risk and return data
• unique legal and tax considerations

Question 2

LOS 60b: Describe categories of alternative investments

Answer 2

• Hedge Funds These are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies. Their aim is to produce positive results, regardless of the performance of the market
• Private equity funds these invest in 1) non-publicly traded companies such as start-ups and 2) public companies with the intention of becoming private. Private equity funds include:
  
  • Leveraged buyout funds (LBOs) these funds borrow money to finance the acquisition of a company. They look for well established companies
  • Venture Capital these funds specialize in providing financing to start-ups or young companies with high growth potential
• Real Estate includes invesments in buildings and/or land, either directly or indirectly. They include:
  
  • Private commercial real estate equity
  • Private commercial real estate debt
  • Public real estate equity
  • Public commercial real estate debt
• Commodities Investors can directly invest in physical commodity products or invest in businesses engaged in the production of physical commodities

Question 3

LOS 60c: Decribe potential benefits of alternative investments in the context of portfolio management

Answer 3

Historically returns on alternative investments have been found to have very low correlation with returns on traditional invesments, so combining the two is a great way to diversify. However there are challenges such as :

• Getting reliable measure of risk and return
• Identifying the appropriate allocation
• selecting portfolio managers

Further more alternative investments have historically exhibited higher returns than traditional investments due to :

• Tax advantages
• Portfolio managers’ ability to exploit mispricings
• Return premium for illiquidity
• Significant use of leverage

It is important to understand the following when evaluating the historical record of alternative investments:

• Reported returns and deviations are averages that may not apply to the short term
• The volatility of returns of alternatives, as well as the correlation with traditional, may be underestimated
• Hedge fund indicies are inherently upward biased due to :
  
  • Self-Selection Bias- performance disclosure is voluntary, so only exceptional results are disclosed
  • Backfiling Bias - only managers with consistently superior track records choose to disclose their performance
  • Survivorship Bias- this occurrs due to the fact that unsuccessful funds go out of business, and their performance is not disclosed, only the successful ones are

Question 4

LOS 60d: Describe hege funds including, as applicable strategies, sub-categories, potential benefits and risks, fee structures, and due dilligence

Answer 4

Hedge Funds General Characteristics

• They are aggresively managed portfolios of investments
• They aim to generate high returns and are not constrained by any significant investment restrictions
• they are set up as private investment partnerships , where the fund is the general partner (GP) and the investors are limited partners (LPs). GPs receives a base fee and an incentive fee. LPs own a fraction and consist of only qualified investors that have good knowledge, wealth, and liquidity
• Hedge funds face little to no regulation
• They impose lock-up periods where investors can not withdraw funds, and usually impose notice periods, which required investors to give days notice before withdrawing funds
• There are also funds of funds– hedge funds that invest in several different hedge funds

Hedge Fund Strategies

• Event driven Strategies- these strategies take a bottom-up view. They focus on short-term events that usually involve potential changes in coporate structure that are expected to affect individual companies
  
  • Merger Arbitrage- the idea that the acquiring company may overpay for the aquisition. So hedge will buy the aquired company stock before the aquisition and then sell it directly after
  • Distressed/Restructuring- since the companies are distressed, their stock is deeply discounted, hedgers will take long positions if they believe the company can pull itself up
  • Activist this strategy focuses on pruchasing sufficient equity in a company to be able to influence its policies and strategic decisions
• Relative value strategies seek to profit from pricing discrepancies between related securities
  
  • Fixed-income convertible arbitrage- These strategies seek to exploit a perceived mispricing between a convertible bond and its component parts. Usually involve purchasing the convertible bond and selling the issuers stock
  • Fixed income asset backed focuses on mispricings from ABSs and MBSs
  • Fixed income general- seek profit from differences in relative values of fixed income securities
  • Volatility take positions on options to go long or short on market volatility
• Macro Strategies: these take a top-down view as they focus on the overall macroeconomic environment
• Equity Hedge Strategies- these take a bottom-up view and focus on public equity markets, taking long and short positions
  
  • Market Neutral- these use fundamental and/or technical analysis to determine if securities are under (long position) or over (short position) valued
  • Fundamental growth- take long positions in companies with expected high growth
  • Fundamental value- take long positions in shares that are undervalued
  • Quantitative directional- use techincal analysis to find under/over valued stocks
    *

Question 5

LOS 60e: Describe the issues in valuing, and calculating returns on hedge

Answer 5

Valuations are essential for calculating hedge fund performance and satifying calls for redemption. Market values are used to value traded securities in the fund portfolios, but estimated values are used for non-traded securities. Some issues are:

• When using market prices, it is common practice for the hedge fund industry to use the average of the bid ask spread, while they really should take the bid price for all long positions and the ask prices for all short positions
• For highly illiquid or non-traded investments, values are estimated using statistical models

Liquidity is a major concern in valuation, and hedge funds apply “haircuts” to quoted prices to reflect a liquidity discount. However this goes against GAAP so hedge funds have started reporting two different net asset values (NAVs):

• trading NAV is based on the size of the position held relative to the total amount outstanding in the issue and its trading volume
• reporting NAV is based on quoted market prices

Investors should consider a number of issues when investing in a hedge including the following:

• Invetment strategy
• investment process
• competitive advantage
• track record
• size and longevity
• management style
• reputation
• etc etc

Question 6

LOS 60f: Describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds

Answer 6

Hedge Funds usually charge two types of fees:

1. A management fee is calculated on assets under management
2. An incentive fee is based on realized profits. they may be subject to :
   
   • A hurdle rate define the minimum threshold that the fund must earn before any incentive fee is paid
     
     • a hard hurdle means that incentive fees are earned only on the return in excess of the hurdle rate
     • a soft hurdle allows incentive fees to be earned on all profits, given that the hurdle rate is passed
   • a high water mark refers the highest value, net of fees, that the fund has reached. The hedge fund must reach a value above the high water mark to earn incentive fees

Fee structures vary across hedge funds. A common structure is “2 and 20”, meaning a 2% management fee and a 20% incentive fee

Question 7

LOS 60g: Describe private equity, including as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due dilligence.

LOS 60e: Describe issues in valuing and calculating returns on private equity

Answer 7

Private equity investment strategies include:

• Leveraged buyouts (LBOs)
• Venture capital
• Developmen capital
• distressed investing

Private Equity Structure and Fees

Private equity funds are structured as partnerships, with the investors being limited partners (LPs) and the firm being the general partner (GP).

• Management Fees are usually calculated as a percentage of committed capital, which is the amount of funds promised by the LPs to the private equity fund
• Incentive Fees are usually earned by the GP only after the LPs have paid back their initial investments.
• In addition to these fees LBO firms may also charge a fee for arranging the buyout of a company, a fee if the deal falls through

Private Equity Strategies:

• Leveraged Buyouts (LBOs) these refer to the acquisitions of public companies or established private companies, where debt is used to finance a significant proportion of the acquisition. They may be categorized as:
  
  • Management buyouts (MBOs) where the company’s current management team acquires it
  • Management buy-ins (MBIs) where the current management team is replaced by the acquiring team, which then runs the company
• The types of companies that are targets for LBOs have the following characteristics:
  
  • stock price is undervalued
  • their management is willing to enter a deal
  • they are currently ineffieciently managed and can perform better with better management
  • they have strong and sustainable cash flow
  • they have low leverage
  • they have a significant amount of physical assets

A typical LBO structure includes equity, bank debt, and high-yield bonds. Mezzanine Financing is also sometimes used, and refers to issuing debt or preferred shares with warrants or conversion options

• Venture Capital (VC) these funds invest in companies that have high growth potential. These investments are typically in the form of equity, though they can be in convertible preferred or convertible debt. Once the capital is invested, venture capitalist become very involved with the company, often sitting of the board. The investments are usually categorized based on the stage of development:

1. The formative stage- refers to investments made when the portfolio company is still in the process of being formed and ecompassed 3 steps:
   
   • Angel Investing- refers to capital provided at the idea stage for the purpose of transforming the idea into a business plan and to evaluate market potential
   • Seed-Stage financing- refers to capital provided to support product development and/or marketing efforts
   • Early Stage financing- refers to capital provided to companies that are moving towards operation, but before commercial production and sales have started
2. Later stage financing (expansion venture capital) is provided after the company has commenced commercial production and sales, but before any IPO. companies can use these funds to expand production or stimulate sale through marketing.
3. Mezzanine-stage Financing is provided to prepare the company to go public

Other private equity strategies include:

• Development capital which involves financing to more mature companies to help them expand. restructure operations, enter new markets, or finance major acquisitions
• Distressed Investing usually involves buying debt of mature companies that are in financial distress

Private Equity Exit Strategies

Private equity firms usually hold companies for an average of 5 years, with variance from 6 months to 10 years. Common exit strategies are:

• Trade Sale: when the company is sold to a strategic buyer, either through auction or private negotiation
• Initial Public Offerings (IPOs)- these involve take the private company public
• Recapitalization- very popular strategy when interest rates are low. Basically the private equity issued debt to fund a dividend distribution to equity holders (including itself). This isn’t an exit strategy but a set-up for an exit
• Secondary Sale- this involves the sale of a company to another private equity firm or group of investors
• Write off/ liquidation- this occurrs if the investment does not perform well

Private equity performance, risk, and diversification

• private equity funds have earned higher returns than equities over the last 20 years
• Based on standard deviation of historical returns, private equity funds entail higher risk
• private equity funds are not perfectly correlated with returns on traditional investments, so there are diversification benefits from adding private equity to the portfolio

Just like hedge funds, these results are voluntary so they may be skewed.

Private Equity Valuation

• Market or comparables approach - This is a relative valuation technique that uses equity multiples of different measures to value a company. Commonly used multiples are based on EBITDA, revenue, and net income.
• Discounted Cash flow approach: the value of a company is determined as the present value of its future cash flows
• Asset-backed approach- values the equity of a company as the total value of its assets minus the value of its liabilities.

Private Equity Considerations and Due Diligence

• Portfolio companies have a better chance when the economy is strong
• Since private equity takes on signigicant leverage, interest rates and capital availability expectations must be considered
• The quality of the GP is also very important

Question 8

LOS 60g: Describe real estate, including as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due dilligence.

LOS 60e: Describe issues in valuing and calculating returns on real estate

Answer 8

Real Estate investments include direct and indirect ownership in real estate property, as well as lending against real estate property. Reasons for these investments are:

• they 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 immune to economic shocks
• it serves as an inflation hedge if rents can be changed quickly to deal with inflation
• it may offer diversification benefits if there is low correlation

Forms of Real Estate Investment can be classifies into different forms on the basis of:

1. Whether the investment is being made in the private or public market

• Investments in private markets can be made directly or indirectly:
  
  • a direct investment can be made by investing in an asset or attaining a claim on the asset
  • An indirect investment can be made through different investment vehicles
• Investments in public markets are usually made indirectly through ownership of securities that serve as claims on the underlying assets. Examples include investment in real estate investment trust (REIT) or real estate operating company (REOC)

1. Wheter the investment is structured as equity or debt

• An equity investor has an ownership interest in real estate or in securities of an entity that owns real estate. Equity investors have control over decisions
• A debt investor is a lender who owns a mortgage loan or mortgage securities. Typically the real estate will serve as collateral for the loan

Within these basic forms, the following variations exist:

• Direct Ownership occurrs when the title of the property is transferred to the owner and there is no financial lien on it
• Leverage Ownership occurs when the property title is attained by the owner by investing her own funds combined with a mortgage loan

Real Estate Investment Categories:

• Residential property: most individuals invest in real estate with the intent to occupy, so real estate investment takes the form of a direct equity investment for them. Most buyers take loans. Lenders have the option to hold the loans or to sell them as MBSs
• Commercial real estate direct (equity and debt) investments in commercial real estate are generally considered appropriate

REITs and commercial mortgage backed securities (CMBS) offer individual investors the opportunity to make indirect equity and debt investments into real estate:

• REITs issue shares that are publicly traded. They provide investors with a diversified real estate portfolio that is professionally managed. Mortgage REITs are similar to fixed-income. Equity REITs are similar to direct equity investments in leveraged real estate
• Timberland and Farmland these properties allow investors to generate income through sales of the produced commodity or by leasing the land to another entity.

Real Estate Performance and Diversification Benefits

• Appraisal Indicies use estimates of value as inputs. Appraisals are performed periodically, causing index returns to be smooth and understate volatility
• Repeat Sales indicies are constructed using changes in prices of properties that have sold multiple times over the period. These indicies suffer from sample selection bias, as properties that have sold multiple times might not be the best
• REIT indicies are constructed using prices of publicly traded shares of REITs. The reliability of these indicies increases with frequency of trading

Real Estate Valuation

• Comparable Sale approach- the value of a property is estimated based on recent sales of comparable properties
• Income Approach there are 2 income based approaches:

1. Direct capitalization approach- estimates the value of a property by dividing expected net operating income generated by the property by a growth implicit capitalization rate
2. Discounted Cash flow approach- estimates the value of a property as the present value of its expected future cash flows over a specific investment horizon plus the present value of an estimated resale value at the end of the holding period

• Cost Approach- under this approach the value of a property is estimated as its replacement cost, which equals the total cost that would be incurred to buy the land and construct new, but similar, property on that site

REIT Valuations

• Income Based approaches for valuing REITS have 2 measures:

1. Funds from operations (FFO) this is calculated as net income plus depreciation charges on real estate property, less gains from sales of real estate property plus losses on sales of real estate property
2. Adjusted funds from operations (AFFO) this is calculated by adjusted FFO for recurring capital expenditures

• Asset- based approach- aims to determine a REIT’s net asset value (NAV) by subtracting the value of its total liabilities from the estimated total market value of its assets

Question 9

LOS 60g: Describe commodities, and other alternative investments, including as applicable, strategies, sub-categories, potential benefits and risks, fee structures, and due dilligence.

LOS 60e: Describe issues in valuing and calculating returns on commodities.

Answer 9

Investments in physical commodities entail costs for transportation and storage. As a result, most commodity investors prefer to trade commodity derivatives instead of actual physical commodities. Besides futures, forwards, and swaps, other commodity investment vehicles include:

• Exchange traded funds (ETFs) these are suitable for investors who are limited to only investing in equities. ETFs may be for commodities or commoditiy futures and have typically lower expense ratios than most mutual funds
• Common stock of companies exposed to a particular commodity For example an investor who wants to gain exposure to oil can invest in BP. This doesn’t mean the performance of the stock will follow the performance of the commodity closely
• Managed futures fund- These are actively managed investment funds that may focus on specific commodity sectors or be broadly diversified. They are similar to hedge funds in that they charge management and incentive fees.
• Individual managed accounts- these are managed by professional money managers on behalf of high net worth individuals

Commodity Performance and Diversification benefits

Studies have shown from 1990-2010:

• Commodities have earned a lower annual return than stocks and bonds
• Commodity returns have been more volitale than stocks and bonds

On a positive note, commodities have a very low correlation with stocks and bonds and they serve as a hedge against inflation

Commodity Price and Investments

Spot prices for commodities are a function of supply and demand, costs of production and storage, value to users, and gloabal economic conditions

• Demand for commodities depends on global manufacturing dynamics and economic growth
• Supply of many commodities is relatively inelastic in the short-run as a result of the extended lead times required to increase production
• As a result commodity prices tend to fluctuate widely due to changes in demand

Pricing of Commodity Futures contracts

Future prices = Spot price (1+ r) + Storage costs - convenience yield

Storage costs are added as the holder of the commodity (writer of the contract) must pay for storage. The convenience yield is for the long position on the contract, as they are without the convenience of holding the commodity for immediate use.

There are three sources of return on a commodity futures contract:

1. 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
2. Collateral yield The interest earned on the collateral depositied to enter into the futures contract
3. Spot Prices These are influenced by current supply and demand

Collectibles- include antiques and fine arts, wine, stamps, coins, jewlery, and sports memorabilia

• They do not provide current income, but have potential for long term capital appreciation
• they are a source of joy for owners
• they are relatively illiquid
• storage costs can be significant

Question 10

LOS 60i: Describe risk management and alternative investments

Answer 10

Risk Management Issues

• Investments in certain types of alternative investments require long holding periods. For example private equity funds have long lockup periods
• Hedge funds and private equity funds are less transparent than other investments
• Investments in many alternative investents are relatively illiquid

Risk Issues for Implementation

• Indicies are widely used to track the performance of several types of alternative investments. Returns therefore may bot really be representative of the risk-return characterisitcs of alternative investments
• Reported correlations between alternative and traditional can be very different from actual correlation
• There can be significant differences between the performance of an individual portfolio manager and the performance of the overall investment class
• Large investors can diversify better than small
• Hedge fund managers who have incurred large losses tend to liquidate their funds instead of trying to offset their losses

Risk-Return Measures

Given the illiquid nature of most alternative investments, estimates of value are normally used. Because they are estimates tho, returns tend to be smooth, and variation tends to be understated, making the Sharpe Ratio non-affective measure of risk.

Further most returns from alternative investments are leptokurtic and negatively skewed (meaning they have positive returns, but higher than average risk of extreme loss). As a result it is better to measure downside risk:

• Value at Risk (VaR) estimates minimum amount of loss expected over a given period of time at a given probability
• Shortfall or safety first measures- they measure the probability that the value of the portfolio will fall below minimum acceptable levels over a given period
• Sortino ratio- This measure of downside risk uses downside deviation as opposed to standard deviation as a measure of risk