Section 4 - R20 - Asset Allocation to AIs (HF, PE, Real Assets, MVO)

Question 1

Functional Role of AI (List)

Answer 1

• Capital Growth (CG)
• Income Generation (I)
• Risk Diversification (RD)
• Safety (S)

Question 2

Hedge Funds (Roles)

Answer 2

• RD (Short Bias, Event-Driven)
• CG (Long Short, Global Macro, Mgd Futures)
• From risk reduce to return enhancement

Question 3

Real Assets (Roles)

Answer 3

• CG (increase in price)
• I (crop, rent, income)
• RD (many have inflation hedge)

Question 4

Private Credit (Roles)

Answer 4

• I (Coupon)
• CG (MTM)
• Concentrated
• Distressed (Equity-Like) and Direct Lending (Similar Credit Profile Behavior)

Question 5

Private Real Estate (Roles)

Answer 5

• CG (appreciates)
• I (rent)
• RD (hedge to unanticipated inflation)

Question 6

Private Equity (Roles)

Answer 6

• CG
• I
• Concentrates with risks as volatility is non observable

Question 7

Risk Conception (difference between short term and long term)

Answer 7

Short Term: Volatility
Long Term: Underperformance

Question 8

Volatility Reduction in Short Term (Concept)

Answer 8

• Unsmoothing where (i) appraisal indexes, (ii) survivorship or (iii) back-fill biases underestimate risk

Question 9

Justify and describe limitations in usage of bonds to mitigate equity risks

Answer 9

1. Bonds have exhibited negative correl with equities (which is good), but
2. Correlation may increase in turbulent times and/or high inflation environment
3. Correlation is temporary
4. Heavy allocation to bonds reduce probability of achieving long-term returns

Question 10

HFs to mitigate equity risks (limitations)

Answer 10

1. If beta is lower than 1, it will reduce overall beta
2. Higher expected returns than equity may help the portfolio in achieving returns
3. Levered strategies that should be used with attention

Question 11

Approaches to Asset Classification (List)

Answer 11

1. Liquidity: REITs, Infra, PE, Real Estate
2. Marketability/Private
3. Based in E(R) during different regimes: Capital Growth (CG), Inflation Hedge (commodities), Deflation Hedge (govt bonds)

Question 12

Risk Based Approaches to Asset Classification (List)

Answer 12

1. Equity Market Return
2. Size
3. Value
4. Liquidity
5. Duration
6. Inflation
7. Credit Spread
8. Currency

Question 13

Traditional Based Approaches to Asset Classification (Pros and Cons)

Answer 13

Pros:
Simple and Easy to Communicate

Cons:
- Overestimate diversification
- Grouping different assets in the same classification (eg. HY and IG Bonds are classified as FI)
- Sensitive to historical look back period.
- Implementation Shortfalls.

Question 14

Traditional Based Approaches to Asset Classification (Pros and Cons)

Answer 14

Pros: Easier to communicate, relevance for liquidity management and operational considerations

Cons: Overestimate asset diversification, obscured primary drivers of risk (as it lists many)

Question 15

Factors to Consider in AI (List)

Answer 15

1. Define risk
2. Establish E(R)
3. Select appropriate investment vehicle
4. Operational Liqudity Issues
5. Expenses and Fees
6. Tax Considerations
7. Dilemma: build or buy

Question 16

MVO in AI (Concept)

Answer 16

It does NOT address the characteristics of most AI classes. Standard Deviation is an unidimensional view.

Reason: assets face illiquidity, it may take several years to extract return, modeled valuation may apply.

Question 17

Types of Investment Vehicles (List)

Answer 17

1. Direct Investment in LP: Asset owner is a LP. Limit’s the investor’s liability to the amount invested in equity. GPs have broad discretion to asset allocation.
2. FoFs: Pools operational risk, diversifies, but loses profitability in fees. Charges additional fees to its services.
3. SMAs / Exclusive Funds: PB clients who want an unique strategy.
4. Mutual Funds / ETFs: Mitigate costs, risk based investment approach, passive income. Scale and liquidy. Tax Efficient