Study Session 13 - Alternative Investments Portfolio Mgmt Flashcards
Common Features of Alt Investments
illiquid (associated with a return premium as compensation)
diversifying potential relative to a portfolio of stocks/bonds
high due diligence costs
performance appraisal is difficult
How to select an active manager for AI?
1) Assess market opportunity offered
2) Assess the investment process
3) Assess the organization
4) Assess the people
5) Assess the terms and structure of the investment
6) Assess the service providers
7) Review Document
8) Write-up
Issues for Private Wealth clients
1) taxes
2) suitability
3) communication
4) decision risk
5) concentrated positions
What are examples of indirect real estate investments?
REITS, CREFs, SMAs, infrastructure funds, and companies that develop and manage real estate
What are REITS?
Real estate investment trusts which are publicly traded equity shares in a portfolio of real estate;
Liquid
permits smaller investors RE exposure
What are CREFs?
commingled real estate funds which are pooled investments in real estate that are professionally managed and privately held – more flexible than REITs
They can be open-end or or closed-end
Restricted to wealthy investors and institutions
Access to RE experts
Usually leveraged and have higher return objectives
Advantages of real estate investment?
low correlation with stocks and bonds low volatility of return often inflation hedge tax advantages potential to leverage return
Disadvantages of real estate investment?
high information and transaction costs political risk related to taxes high operating exp high commissions special geographical risks inability to subdivide direct investments large idiosyncratic risk component
Private equity: 2 subcategories
1) Venture Capital
2) Buyout funds
What are Traditional Alternative Investments?
primarily provide exposure to risk factors not easily accessible by stock/bond:
1) real estate
2) (long-only) commodities
What are Modern Alternative Investments?
provide exposure to specialized investment strategies run by outside manager (added value heavily depended on skills of manager):
1) HFs
2) managed futures
What are Alternative Investments that combine the feature of modern and traditional?
1) Private Equity funds
2) distressed securities
What is decision risk?
risk of changing strategies at the point of max loss
risk is increased by strategies that by nature have 1) frequent small positive returns but likely to have large losses
2) frequent big swings in returns
Size of real estate market?
1/3 to 1/2 of world’s wealth
What is the benchmark for direct real estate investment?
NCREIF Property index
value weighted, quarterly benchmark - sample of commercial pptys
property appraisal based
not investable index
What is the problem with NCREIF Index?
due to infrequency of appraisals, values exhibit remarkable inertia - index tends to underestimate volatility of underlying values and SMOOTHing bias
What is NAREIT?
principal benchmark for REITs
real-time, monthly computed, market-cap weighted index of all REITS traded on exchange
How do you unsmooth NCREIF?
By using transaction based data
Which real estate benchmark is leveraged?
NCREIF represents nonleveraged investment only
REITS are often has >50% in debt so levered exposure to real estate, thus higher standard deviation
What is the performance of real estate investments?
REITs have high return= 12.71% and high s=12.74%
Appraisal-based RE have low return=6.14% and low s=3.37%
if smoothed, s doubles
What is a “hedged” REIT return series?
remove overall equity market return part
What is RE role in portfolio?
Asset allocation increasing
Diversifier in portfolio, diversification within RE itself, and investment globally
What are two segments of buyout funds?
Middle-market and mega-cap
Middle-market buyout funds
funds concentrated on spin-offs from large parents
- can’t efficiently get capital
Mega-cap buyout funds
funds concentrated on taking publicly traded firms private
How do buyout funds add value?
1) restructure company’s ops/mgmt
2) buying companies for less than intrinsic value
3) creating value by leverage/restructure existing debt
What are exit strategies for buyout funds?
1) selling companies thru private placements
2) IPOs
3) div recapitalizations
Dividend Recapitalizations
Under direction of buyout fund, company issues large debt and pays large special dividend to buyout fund and other equity investors - changes company’s leverage but not owners (still retains control)
Commodity Investment Properties
direct or indirect investments
liquid
low correlation with stocks/bonds and business-cycle sensitivity
positive correlation w/ inflation
Hedge funds classifications
equity market neutral convertible/FI/merger arbitrage distressed securities hedged equity global macro emerging markets FOFs
Managed Futures holdings
trade only derivatives markets (vs. HFs trades spot/futures) - more macro view
Managed Futures accounts
private commodity pools
CTA managed accts
publicly traded commodity futures funds - available to small investors
Managed Futures trading strategies
Systematic Trading strats – follows rules
includes Trend-following and Contrarian strats
Discretionary Trading strats – depend on mgmt judgement
may invest in all financial markets, current mkt only or mix of derivatives and underlying commodities
How does managed futures’ std deviation compare to stock and bonds?
generally between stock and bonds
correlation to equities is low and often negative
correlation to bonds is higher but below 0.50
What is the risk/return of buyout funds?
less risk then VC funds - good diversification
What is risk/return of Infrastructure funds?
low risk/return - good diversification
What is risk/return of distressed securities?
depends on skill-based strategies - can earn higher returns due to legal complications and due to others not being able to invest in them
relatively high avg return but large negative skew - can’t compare and Sharpe ratios are misleading
What is distressed securities?
may be part of he
Issuers of Venture Capital
companies seeking capital
Formative-stage companies
new or young firms
Expansion-stage companies
need funds to expand revenues or prep for IPO
Investors/Suppliers of VC investing
venture capitalists - speclists
Corporate venturing - large firms that invest in VC oppty
angel investors - expert individuals who are first to invest (non-founders or relatives)
Stages of private companies
Early stage - seed money
Start-up funds - begin product development/marketing
First-stage funding - begins manufacturing/sales
Expansion stage - young companies with established products looking to grow or launch IPO
Second-stage financing – supports add’l major expansion of production/sales
Third-stage financing - “”
Mezzanine/Bridge Financing – prep for IPO (may be include debt and equity capital)
EXIT stage - IPO, merger or acquisition (may be VC fund specializing in such activity)
VC vs Buyout funds
Buyout funds have... higher leverage earlier and steadier cash flows less error in return measurement (since mostly cash) less frequent losses less upside potential
Direct VC investment in Convertible Preferred Stock
pref shareholders must be paid a specified amount ahead of common shareholders
typically - investors in later rounds of financing receive pref stock with claim that is senior that previously issued pref stock
seniority is included to entice subsequent investors
Typical structure of private equity fund
limited partnerships (sponsor = general partner) LLCs (sponsor = managing director)
Private equity strategy issues
1) low liquidity
2) diversification through a of positions
3) diversification strategy
4) plans for meeting capital calls - investor needs to be be prepared to meet the commited funds calls
Indirect vs. Direct commodity investment
direct - more exposure but has carrying costs, increase # of investable indices so makes it avail to smaller investors
indirect - more convenient but may be very little exposure especially if company is hedging risk itself
What are components of the return in commodity futures?
total return = spot return +collateral return + roll return
What is collateral return?
periodic risk-free return
Roll Yield/return
change of futures contract price for the time period minus change in spot price of the commodity for the period
Bacwardation
downward-sloping term structure of futures prices (price gets lower into the future)
positive roll return = future price increases to converge with spot price
Contango
upward-sloping term structure of futures prices
negative roll return
Why is commodity a good unexpected inflation hedge?
storability and demand relative to economic activity
5 segments to HF strategies
1) RV
2) event-driven
3) hedged equity
4) global asset allocators
5) shorting
High Water Marks
avoid incentive fee double-dipping
Lock-up Period
limit withdrawals by requiring minimum investment period and pre-set exit windows
HF performance conventions
Funds do better when…
have longer lock-up periods then short
youger funds vs. older
smaller funds vs. bigger
Downside Deviation
measures dispersion of returns below specified threshold return - usually either zero or risk-free rate of return
if threshold = recent avg return then downside deviation is called semivariance
purpose is to focus only on negative returns and not on high positive returns (i.e. so it doesn’t look like they are more risky for having large high returns and a few avg positive ones)
Sharpe Ratio formula
(return - risk free rate)/ std
Sharpe Ratio limitations
time dependency assumes normality assumes liquidity assumes uncorrelated returns stand-alone measure
Managed futures benefits
significant diversification potential (impoved Sharpe ratios)
positive correlation to equities/bonds in up markets
negative correlations during falling markets
private funds add value vs. publicly traded funds do poorly
CTA correlations
risk - CTAS often show negative correlations w/ equities and correlations between CTAs range from 1 to modestly positive
whats a good indicator of future risk-adjusted performance of CTAs?
beta – relates performance of individual CTA to fund of CTAS
Major types of Distressed Securities investing
1) long-only value investing
2) distressed debt arb
3) private equity
“fallen angel”
issue of debt fallen from investment grade to below-investment grade
High-yielding investing
buying publicly traded, below-investment grade debt
Orphan equities investing
buying firm equity of companies emerging from reorg
Distressed debt arb
buying firm’s distressed debt while shorting company’s equity
How is private equity “active” approach?
investor buys positions in distressed company and gets some measure of control
Vulture Funds
specialize in buying undervalued distressed securities
Distressed securities investing concerns
Event Risk
Market Liquidity risk
Market risk
J-factor risk
Type of commodities not good to hedge against unexpected inflation
nonstorable commodities (i.e. agricultural like corn, livestock, etc.) - negatively affected by unexpected increases to inflation
