CAIA level II advanced core topics in alternative investments 2e sample black donald and hossein

Contents vii11.3 Information Gathering in the Monitoring Process 139 CHAPTER 12 Private Equity Fund Valuation 145 CHAPTER 13 Private Equity Fund Discount Rates 151 CHAPTER 14 The Managem

CAIA Level II

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CAIA Level II

Advanced Core Topics

in Alternative Investments

Second Edition

KEITH H BLACK DONALD R CHAMBERS

HOSSEIN KAZEMI MARK J.P ANSON GALEN BURGHARDT FRANCOIS-SERGE LHABITANT

JIM LIEW SUSAN LIEW GEORGE A MARTIN PIERRE-YVES MATHONET DAVID F McCARTHY THOMAS MEYER EDWARD SZADO BRIAN WALLS

John Wiley & Sons, Inc.

Copyright  C 2009, 2012 by The CAIA Association All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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PART ONE

Asset Allocation and Portfolio Management

CHAPTER 2

2.2 Intergenerational Equity, Inflation, and Spending Challenges 10

CHAPTER 3

Risk Management for Endowment and Foundation Portfolios 21

Pension Fund Portfolio Management 33

v

5.2 Main Differences between Venture Capital and Buyout 50

5.4 Private Equity Funds of Funds as Intermediaries 56

5.6 The Relationship Life Cycle between Limited and General Partners 59

CHAPTER 9

Fund Manager Selection Process 1079.1 Determination of the Wish List of Fund Characteristics 107

Contents vii

11.3 Information Gathering in the Monitoring Process 139

CHAPTER 12

Private Equity Fund Valuation 145

CHAPTER 13

Private Equity Fund Discount Rates 151

CHAPTER 14

The Management of Liquidity 161

Real Estate as an Investment 181

CHAPTER 16

Unsmoothing of Appraisal-Based Returns 191

CHAPTER 17

Core, Value-Added, and Opportunistic Real Estate 20717.1 Defining the Three NCREIF Real Estate Styles 208

viii CONTENTS

17.6 Developing Risk and Return Expectations with Styles 215

CHAPTER 18

CHAPTER 21

Farmland and Timber Investments 257

21.4 Commodity Price Volatility and Its Implication for

CHAPTER 22

Investing in Intellectual Property 279

24.3 Sources of Return to Futures-Based Commodity Investment 31924.4 The Statistical Properties of Commodity Prices 320

25.5 Fundamental Analysis for Directional and Relative

CHAPTER 26

Methods of Delivering Commodity Beta: Indices, Swaps, Notes,

26.5 Commodity Indices Compared to Securities Indices 351

26.8 Performance Enhancements of Enhanced

26.9 A Primer on Commodity Index Calculation: Spot, Roll,

x CONTENTS

CHAPTER 27

Macroeconomic Determinants of Commodity Futures Returns 363

CHAPTER 28

Effective Risk Management Strategies for Commodity Portfolios 379

Structure of the Managed Futures Industry 391

30.3 Efficient Market Hypothesis and Returns to CTAs 41330.4 Profitability of Momentum-Based and Other Trend-Following

32.2 Issues in Structuring a CTA Investment Program 454

32.7 Comparison of Approaches to Structuring a

32.9 Investment and Operational Due Diligence Processes 468

CHAPTER 33

34.6 Convertible Arbitrage in Practice: Stripping and Swapping 515

CHAPTER 35

Global Macro and Currency Strategies 521

xii CONTENTS

35.5 A More Complex Trade: Contingent Yield

35.6 Risk Management and Portfolio Construction 536

CHAPTER 36

Fundamental Equity Hedge Fund Strategies 539

36.2 Background of the Long/Short Equity Hedge Fund 543

36.4 Managerial Expertise and Sources of Returns 547

CHAPTER 37

Quantitative Equity Hedge Fund Strategies 553

CHAPTER 38

38.7 Due Diligence Issues Arising in the Context of Funds

38.10 Funds of Funds versus Individual Hedge Funds 593

Contents xiii

CHAPTER 40

Operational Due Diligence 617

Since its inception in 2002, the Chartered Alternative Investment Analyst (CAIA)Association has incorporated state-of-the-art reading materials into its curricu-lum This latest curriculum reading represents a milestone in our efforts to con-tinuously improve and update our curriculum To ensure that the material bestreflects current practices in the area of alternative investments, the CAIA Associationinvited a group of leading industry professionals to contribute to the production

of the series, covering core areas of alternative investments: private equity, realassets, commodities, hedge funds, and managed futures Similar to other books pub-lished by the CAIA Association, this book is grounded in the CAIA program’s CoreKnowledge Outline

In publishing the books in this series, we are guided by the Association’s mission

to provide its members with a comprehensive knowledge of alternative investments,

to advocate high standards of professional conduct, and to establish the CharteredAlternative Investment Analyst Charter as the educational gold standard for thealternative investment industry

T E N Y E A R S O F C A I A A N D A L T E R N A T I V E I N V E S T M E N T S

The quality, rigor, and relevance of this series derive from the ideals on which theCAIA Association is based After its founding in 2002, the first Level I examinationwas offered in February 2003, with the first Level II examination taking place inOctober 2003 I was privileged to be among the first class of 43 candidates whopassed the Level I and Level II exams, met the other requirements of membership, andwere invited to join the CAIA Association Many of these founding members wereinstrumental in establishing the CAIA Charter as the global mark of excellence inalternative investment education After just 10 years, we now have more than 5,700members in 75 countries Those who become members of the CAIA Association havethe opportunity to network with other CAIA members, including attending eventssponsored by CAIA’s 15 chapters, located in financial centers worldwide

The growth of CAIA, from 43 members to more than 5,700 members in 10 years,closely parallels the growth of the alternative investments industry Preqin estimatesthat private equity assets in December 2002 were $767 billion, while closed-endprivate real estate assets under management (AUM) totaled just $81 billion At thesame time, Hedge Fund Research estimates that the hedge fund industry managed

$625.5 billion By 2011, assets across all alternative investment types had exploded,with hedge funds managing over $2,000 billion, private equity controlling nearly

$3,000 billion, and private real estate investing over $500 billion (See ExhibitsP.1 and P.2) In 2003, infrastructure and commodity assets likely totaled less than

$20 billion While these asset classes were nascent in 2003, Preqin now estimates

xv

806 1,011

1,265 1,204

1,075 1,067 1,413 1,783

2003 Dec.

2004 Dec.

2005 Dec.

2006 Dec.

2007 Dec.

2008 Dec.

2009 Dec.

2010 Jun 2011

Dry Powder ($bn) Unrealized Value ($bn)

is the amount of assets controlled by, or committed to, closed-end funds that hasnot yet been invested by the fund manager Larger amounts of dry powder indicatethe amount of cash available to invest in the underlying assets, which leads somemarket participants to predict higher deal volume and asset valuation in the comingquarters

T H E H I S T O R Y O F C A I A

The CAIA Association was introduced to the investment community in 2002 by rence Lombard, then Chief Executive Director of the Alternative Investment Man-agement Association (AIMA), and Dr Thomas Schneeweis, Director of the Center

Flo-0

Dec 2002

40 72 57

98 99

Dec 2003 Dec 2004 Dec 2005

Dry Powder ($bn) Unrealized Value ($bn)

Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Jun 2011

E X H I B I T P 3 Growth of CAIA Membership

Source: CAIA Association.

for International Securities and Derivatives Markets (CISDM) Ten years ago, gether with a core group of academic and industry experts determined to fill anunmet need for a standard of education in this bourgeoning sector, they launchedthe CAIA Charter

to-Like the sector of the industry it covers, the CAIA Association has grown rapidly

In 2008, the New York Society of Security Analysts recognized CAIA as the growing financial credential, and in the past three years alone, membership hasmore than doubled to more than 5,700 Fostered by a dedicated chapter relationsteam, the number of CAIA chapters has tripled to 15 from the first five chaptersestablished in 2005; CAIA chapters now provide a platform for educational, career,and networking activities for thousands of alternative investments professionals inthe world’s major financial centers CAIA now has six offices globally

fastest-As the fastest-Association has grown, its program has evolved and advanced In 2009,CAIA introduced the first editions of the most complete, authoritative desktop refer-

ence volumes on alternative investments ever created: CAIA Level I: An Introduction

to Core Topics in Alternative Investments and CAIA Level II: Advanced Core Topics

in Alternative Investments, written and edited exclusively by leading practitioners

and academics Now, in 2012, CAIA Association has published second editions ofthese volumes to keep pace with the latest strategies and information Along with

CAIA Level II: Core and Integrated Topics (which is revised annually to contain the

most advanced material) and the Standards of Practice Handbook published by CFA

Institute, these volumes round out a complete education in alternative investmentsfor any finance professional

CAIA has also continually provided ongoing educational resources to serve its

growing member and candidate base The suite of offerings includes the Journal of

Alternative Investments, the official publication of the CAIA Association, and native Investment Analyst Review, a digital research digest designed to make keeping

Alter-abreast of the latest research easier It also includes the member Self-Evaluation Tooland Member Library, designed to work together to help members stay current onthe latest knowledge in alternative investments; multimedia content; educational andconference discounts; and more

xviii PREFACE

The Association formalized its commitment to advancing the alternative ment industry now and in the future by establishing the CAIA Foundation in 2011.The Foundation partners with sponsors to fund research and scholarships, raisingthe standard of knowledge and the talent pool in the alternative investment industryfor the ultimate benefit of the investor

invest-B E N E F I T S O F T H E C A I A P R O G R A M

CAIA has become the leading-edge alternative investment credential and the challenged leading provider of education in alternative investments Although theestablishment of the CAIA Association was largely due to the efforts of professionals

un-in the hedge fund and managed futures space, these founders correctly identified avoid in the wider understanding of alternative investments as a whole From thebeginning, the CAIA curriculum has also covered private equity, commodities, andreal assets, always with an eye toward shifts in the industry Today, several hundredCAIA members identify their main area of expertise as real estate or private eq-uity; several hundred more are from family offices, pension funds, endowments, andsovereign wealth funds that allocate across multiple classes within the alternativeinvestment industry Investment professionals in any asset class, such as real estateprofessionals, can benefit from a broad-based education in alternative investments,

as it is important to see the big picture of institutional portfolios An understanding

of the investment goals and practices of institutional investors, including pensions,sovereign wealth funds, endowments, and foundations, is important for both insti-tutional investors and managers of alternative investment products

To accomplish this comprehensively, we have fully developed curriculum committees that represent each area of coverage within the curriculum All of thesealternative investment areas share many distinct features, such as the relative free-dom on the part of investment managers to act in the best interests of their investors,alignment of interests between investors and management, relative illiquidity of po-sitions for some investment products, and deviations from some of the underpinningassumptions of modern portfolio theory These characteristics necessitate concep-tual and actual modifications to the standard investment performance analysis anddecision-making paradigms

sub-Readers will find the publications in our series beneficial, whether from thestandpoint of allocating to new asset classes and strategies in order to gain broaderdiversification or from the standpoint of a specialist needing to better understand thecompeting options available to sophisticated investors globally In either case, readerswill be better equipped to serve their clients’ needs The series has been designed

to make studying more efficient relative to our past curriculum Importantly, it ismore relevant, having been written under the direction of the CAIA Associationwith the input and efforts of many practicing and eminent alternative investmentprofessionals, as reflected in each publication’s acknowledgments section

S T U D Y I N G F O R T H E C A I A E X A M S

“Foundations of the CAIA Curriculum” is an assessment tool for determining a didate’s readiness to enter the CAIA program These foundational materials cover

can-Preface xix

the quantitative analytics commonly associated with traditional assets, as well as ablend of practical and theoretical knowledge relating to both traditional and alter-native investments

The first book in our series, CAIA Level I: An Introduction to Core Topics in

Alternative Investments, is a twice-revised edition of Mark Anson’s Handbook of Alternative Assets The CAIA Level I required readings are contained in this one text,

supplemented only by the CFA Institute’s Standards of Practice Handbook Readers

should be aware, however, that the Foundations program is important and that Level

I candidates are assumed to have mastered all of the content in the Foundations guide

in advance of taking the Level I exam

The second book in our series, CAIA Level II: Advanced Core Topics in

Al-ternative Investments, also represents a significant advancement in the coverage of

our curriculum The tools candidates develop in Level I of the CAIA program areapplied in the Level II curriculum, which both integrates alternative investments intoinvestor portfolios and presents risk management across asset classes We believethis new model of curriculum development accurately reflects the skill set required

of industry practitioners

The third volume in this series is titled CAIA Level II: Core and Integrated

Topics It is updated annually and designed to address topics that cut across all areas

of alternative investments, such as asset allocation and risk-management techniques,

as well as new developments in the alternative investment research space and inthe industry itself This book is more frequently revised, which allows the Level IIcurriculum to rapidly adapt to new research trends in alternative investments ascovered in academic and practitioner journals

Finally, we will continue to update both the CAIA Level I Study Guide and the CAIA Level II Study Guide every six months (each exam cycle) These guides,

available for free download at http://caia.org, outline all of the readings and sponding learning objectives (LOs) that candidates are responsible for meeting Theyalso contain important information for candidates regarding the use of LOs, testingpolicies, topic weightings, where to find and report errata, and much more The

corre-entire exam process is outlined in the CAIA Candidate Handbook and is available

at http://caia.org/caia-program/exams/candidate-handbook

I believe you will find this series to be the most comprehensive, rigorous, andglobally relevant source of educational material available within the field of alterna-tive investments

It is my sincere wish that this volume contributes to the continuing growth ofthe alternative investments industry and, in particular, to the career growth of CAIAmembers and CAIA candidates

KEITHH BLACK, PhD, CFA, CAIA

Associate Director of Curriculum CAIA Association

September 2012

We would like to thank the many individuals who played important roles inproducing this book Each section of this volume was developed by a set ofmain authors; however, several others were instrumental in bringing this project

to its completion Hossein Kazemi; Nelson Lacey; Donald R Chambers, CAIA;and Kristaps Licis contributed greatly by providing and revising content in allsections, assisting with the development of the initial section outlines, which arebased on the CAIA Core Knowledge Outline (CKO), and reviewing several sectiondrafts The following people were instrumental in bringing this project to its com-pletion: Aaron Cunningham, CAIA; Brad Case, CAIA; Eliot Geller, CAIA; HilaryTill; James Bachman, CAIA; James Burron, CAIA; Jason Campbell, CAIA; KlausSpringer, CAIA; Robert Murphy, CAIA; Sam Gallo, CAIA; Sue Bannon, CAIA;Robert O’Donnell, CAIA; Jean Michaud; Christine Gaelzer; Thomas Schneeweis; andTimothy Peterson, CAIA

Keith Black, CAIA, is the author of the first section on asset allocation andportfolio management The main authors of the private equity section are Pierre-YvesMathonet and Thomas Meyer The main author of the real estate section is Donald

R Chambers, CAIA, with contributions from Mark Anson, CAIA Chapters ontimberland, farmland, and intellectual property were contributed by George Martin.The main author of the commodities section is Ed Szado, while chapters were alsocontributed by Moazzam Khoja, Zeno Adams, Roland Fuss, and Dieter Kaiser.Chapters on hedge funds and managed futures were authored by Hossein Kazemi,David McCarthy, Jim Liew, Susan Liew, and Keith Black, CAIA

Finally, the second edition contains substantial content from the first edition ofthe book Additional authors from the first edition include Urbi Garay, Ernest Jaffar-ian, Melissa Donohue, Richard Spurgin, Francois Lhabitant, and Simon Stevenson.Importantly, we owe great thanks to Florence Lombard, Chief Executive Officer

of the CAIA Association, and our committee members:

Curriculum Advisory Council

Mark Wiltshire, CAIA

Real Assets Committee

Stephane Amara, CAIA

George A Martin

Andreas Calianos

Tom Johnson, CAIA

Asif Hussain, CAIA

Commodities and CTAs Committee

Hamlin Lovell, CAIA

James Bachman, CAIA

Erik Benrud, CAIA

Gitanjali M Swamy

Due Diligence and Regulation Committee

Jaeson Dubrovay, CAIA

Armand van Houten, CAIA

Tom Kehoe, CAIA

Hamlin Lovell, CAIA

Christopher Schelling, CAIA

Mark Wiltshire, CAIA

Asset Allocation, Risk Management, and Wealth Management Committee

Solomon Tadesse

Joelle Miffre

James T Gillies, CAIA

Pierre Laroche

Acknowledgments xxiii

Structured Products Committee

Jon Rotolo

Samson Koo

CAIA Curriculum Group

Hossein Kazemi, PhD, CFA, Program Director

Donald Chambers, PhD, CAIA, Associate Director and Level I ManagerKeith Black, PhD, CFA, CAIA, Associate Director and Level II ManagerJeanne Miller, Project Manager

Andrew Tetreault, Curriculum Assistant

Samantha Dodge, Editorial Consultant

Jamie Thaman, Editorial Consultant

About the Authors

Keith H Black, PhD, CFA, CAIA, has over 20 years of financial market

experi-ence, serving approximately half of that time as an academic and half as a traderand consultant to institutional investors He currently serves as Associate Direc-tor of Curriculum for the CAIA Association During his most recent role at EnnisKnupp + Associates, he advised foundations, endowments, and pension funds ontheir asset allocation and manager selection strategies in hedge funds, commodi-ties, and managed futures Prior experience includes commodities derivatives trading

at First Chicago Capital Markets, stock options research and Chicago Board tions Exchange (CBOE) market making for Hull Trading Company, and buildingquantitative stock selection models for mutual funds and hedge funds for ChicagoInvestment Analytics Dr Black previously served as an assistant professor and se-nior lecturer at the Illinois Institute of Technology’s Stuart School of Business, where

Op-he taught courses in both traditional and alternative investments

He contributes regularly to the CFA Digest, and has published in the

Jour-nal of Global Financial Markets, the JourJour-nal of Trading, the JourJour-nal of Financial Compliance and Regulation, the Journal of Investing, the Journal of Environmental Investing, and Derivatives Use Trading and Regulation He is the author of the book Managing a Hedge Fund Dr Black was named to Institutional Investor magazine’s

list of “Rising Stars of Hedge Funds” in 2010

Dr Black earned a BA from Whittier College, an MBA from Carnegie MellonUniversity, and a PhD from the Illinois Institute of Technology He has earned theChartered Financial Analyst (CFA) designation and was a member of the inauguralclass of the Chartered Alternative Investment Analyst (CAIA) candidates

Donald R Chambers, PhD, CAIA, is Associate Director of the Level 1 Curriculum

at CAIA and is the Walter E Hanson KPMG Professor of Finance at LafayetteCollege in Easton, Pennsylvania He has published 50 articles and numerous books

on investments, corporate finance, and risk management He received a PhD infinance from the University of North Carolina at Chapel Hill and a BS in accountingfrom SUNY–Binghamton

Dr Chambers previously served at the University of Baltimore, Rochester tute of Technology, Pennsylvania State University, and University of North Carolina

Insti-at Chapel Hill He served Insti-at Karpus Investment Management as Director of native Investments Dr Chambers earned the CAIA designation in September 2003

Alter-as a member of the first group of candidates to complete the requirements

Hossein Kazemi, PhD, CFA, is the Program Director for the CAIA Association He

oversees the development, execution, and analysis of the CAIA program’s curriculumand examinations Dr Kazemi is one of co-founders of the CAIA Association Inaddition, he has worked with universities and industry organizations to introduce

xxv

xxvi ABOUT THE AUTHORS

them to the CAIA program Dr Kazemi is a professor of finance at the IsenbergSchool of Management at the University of Massachusetts, Amherst Dr Kazemi

is currently an Associate Director of the Center for International Securities andDerivatives Markets, a nonprofit organization devoted to research in the area ofalternative investments, a co-founder of the CAIA Association, and home to CISDMHedge Fund/CTA Database He was involved in the development of first investable

hedge fund indices as well He is an associate editor of the Journal of Alternative

Investments His research has been in the areas of valuations of equity and

fixed-income securities, asset allocation for traditional and alternative asset classes, andevaluation and replication of active management investment products He has a PhD

in finance from the University of Michigan

Mark J.P Anson, PhD, CAIA, is a Managing Partner at Oak Hill Investment

Man-agement, LP Dr Anson previously served as President and Executive Director of vestment Services at Nuveen Investments, Chief Executive Officer at Hermes PensionManagement Limited, and Chief Investment Officer at California Public Employees’Retirement System He has published over 100 research articles in professional jour-nals, has won two “Best Paper” awards, is the author of six financial textbooks, andsits on the editorial boards of several financial journals

In-Galen Burghardt, PhD, is Senior Director of Research for Newedge USA, LLC, a

joint venture between Calyon and Societe Generale He is the lead author of The

Treasury Bond Basis and The Eurodollar Futures and Options Handbook, which are

standard texts for users of financial futures His latest book, written with Brian Walls,

is Managed Futures for Institutional Investors: Analysis and Portfolio Construction

(Bloomberg/Wiley, 2011) He was an adjunct professor of finance in the University

of Chicago’s Graduate School of Business (now the Booth School) He was the head

of financial research for the Chicago Mercantile Exchange, and gained access to theworld of futures through his work in the Capital Markets Section of the FederalReserve Board His PhD in economics is from the University of Washington inSeattle

Francois-Serge Lhabitant, PhD, is currently the CEO and CIO of Kedge Capital,

where he runs more than $6.5 billion invested in hedge fund strategies He wasformerly a member of senior management at Union Bancaire Priv´ee, where he was incharge of quantitative risk management and subsequently of quantitative analysis foralternative portfolios Prior to this, Dr Lhabitant was a Director at UBS/Global AssetManagement, in charge of building quantitative models for portfolio managementand hedge funds On the academic side, he is currently a professor of finance atthe EDHEC Business School (France) and a visiting professor at the Hong KongUniversity of Science and Technology

Jim Liew, PhD, is the CEO of JKL Capital Management, LLC He is also an

adjunct professor of finance at New York University Stern School of Business,where he teaches the course Hedge Fund Strategies Dr Liew also taught thecourse Statistical Arbitrage at Columbia, Baruch, and Johns Hopkins Previously,

he worked at a large macro quant fund and at an ultrahigh-frequency statistical

About the Authors xxvii

arbitrage fund, where he built, backtested, and implemented systematic investmentstrategies

Dr Liew has extensive business experience within the fund-of-funds industry,which includes starting a successful hedge-fund-of-funds business that eventuallyspun out of the Carlyle Group, managing the World Bank’s pension fund directinvestments into hedge funds, and sourcing hedge funds and creating institutionalinvestment products at a well-known managed account platform He has publishednumerous articles on hedge fund investing and quantitative investment strategies

Dr Liew currently consults and advises hedge funds, individuals, and institutions onalternative investment opportunities

Dr Liew obtained his PhD in finance from Columbia Business School He

currently serves on the Editorial Advisory Board of the Journal of Portfolio

Management.

Susan Liew, JD, served as the Chief Compliance Officer at Calypso Capital

Manage-ment, LLC Mrs Liew is admitted to practice in New York

George A Martin is an associate director at the Center for International Securities

and Derivatives Markets (CISDM) at the University of Massachusetts at Amherst

He is also a member of the Real Assets Curriculum Subcommittee of CharteredAlternative Investment Analyst (CAIA) Association and an editorial board member

of the Journal of Alternative Investments As part of his research endeavors, he has

published a large number of papers on alternative assets, including hedge funds,commodities and real assets, and is a frequent speaker on such subjects He is alsocommercially active, as a principal at Alternative Investment Analytics, LLC, and

as Senior Advisor to Wood Creek Capital Management, an asset management firmthat specializes in real assets Previously, he was a research fellow at the BrookingsInstitution He has BA and MA degrees from Johns Hopkins University

Pierre-Yves Mathonet is head of the private equity risk management division of the

European Investment Fund He is a permanent member of the private equity committee of the Chartered Alternative Investment Analyst Program and of the RiskMeasurement Guidelines working group of the European Private Equity and VentureCapital Association (EVCA) He is also co-directing the Certificate in InstitutionalPrivate Equity Investing (CIPEI) course held by the Oxford Said Business School’sPrivate Equity Institute Before that, he worked as an investment banker in the tech-nology groups of Donaldson, Lufkin & Jenrette and Credit Suisse First Boston and,previously, for the audit and consulting departments of PricewaterhouseCoopers

sub-Pierre-Yves co-authored several books, including Beyond the J-Curve and

J-Curve Exposure He holds a master of science cum laude in finance from London

Business School and a master of science magna cum laude in management fromSolvay Business School in Brussels He is also a Certified European Financial Analystcum laude

David F McCarthy, PhD, is the Principal of D.F McCarthy LLC, a consulting and

advisory firm In 2002, he co-founded Martello Investment Management, LP, a cialist fund of funds and advisory firm concentrating on absolute return hedge fund

spe-xxviii ABOUT THE AUTHORS

strategies, including global macro and commodity trading adviser (CTA) strategies.From 1994 to 2000, Dr McCarthy was an investment manager for Global AssetManagement (GAM), where he managed GAM’s trading funds of funds He hasbeen an investment officer with the Atlantic Philanthropies, a partner in Raynerand Stonington, a deputy manager of the International Financial Advisory Service

of Brown Brothers Harriman & Co., and a consultant with McKinsey & Co Dr.McCarthy is a faculty member of Fordham University in New York and UniversityCollege Cork in Ireland He is a contributor to the Greenwich Roundtable “BestPractices in Hedge Fund Investing” series, and is the author of a number of academicarticles on managed futures He holds a PhD from University College Dublin, anMBA from Stanford University, and a BA from the University of New Hampshire

Thomas Meyer is a co-founder of LDS Partners, an advisory firm providing solutions

for liquidity, portfolio, and risk management for institutional investors in privateequity funds After 12 years in the German Air Force, Thomas worked for theGerman insurance group Allianz AG in corporate finance and as the regional chieffinancial officer of Allianz Asia Pacific in Singapore He was responsible for thecreation of the risk management function at the European Investment Fund He is aShimomura Fellow of the Development Bank of Japan and was a visiting researcher atHitotsubashi University in Tokyo and a director of the European Private Equity andVenture Capital Association Dr Meyer is co-directing the Certificate in InstitutionalPrivate Equity Investing (CIPEI) course held by the Oxford Said Business School’sPrivate Equity Institute He is a member of the private equity subcommittee of theChartered Alternative Investment Analyst Program and co-authored a series of books

(e.g., Beyond the J-Curve and J-Curve Exposure).

Edward Szado, PhD, CFA, is the Director of Research of the Institute for Global Asset

and Risk Management (INGARM) and a research associate at the Center for tional Securities and Derivatives Markets (CISDM) He has a PhD (ABD) in finance

Interna-at the Isenberg School of Management, University of Massachusetts, Amherst He is

at present a coeditor of the Alternative Investment Analyst Review and an assistant editor of the Journal of Alternative Investments He has taught corporate finance,

bank management, and risk management at the Isenberg School of Management,University of Massachusetts, Amherst, and the Graduate School of Management,Boston University He is a former options trader, and his experience includes productdevelopment in the areas of volatility-based investments and structured investmentproducts He is also a Chartered Financial Analyst and has consulted for the OptionsIndustry Council, the Chicago Board Options Exchange, the Chartered AlternativeInvestment Analyst Association, and the Commodity Futures Trading Commission

His publications include articles in the Journal of Alternative Investments, the

Jour-nal of Trading, the JourJour-nal of Investing, Alternative Investment AJour-nalyst Review, Alternative Investment Quarterly, Journal of Investment Consulting, and the Invest- ments and Wealth Monitor.

Brian Walls is the Global Head of Research at Newedge Alternative Investment

So-lutions, the foremost provider of brokerage services to the managed futures industry

He has worked in the financial services industry for 30 years in the various capacities

About the Authors xxix

of trading, operations, management, and research He was a pioneer of capital duction services and is a sought after and trusted adviser to many commodity tradingadvisers, global macro managers, fund of funds, and institutional investors He isthe chairman of the Newedge Index Committee Brian is the co-author, with Galen

intro-Burghardt, of Managed Futures for Institutional Investors: Analysis and Portfolio

Construction, published by John Wiley & Sons in April 2011.

CAIA Level II

CHAPTER 1

Introduction

This second edition of CAIA Level II: Advanced Core Topics in Alternative

Investments represents a substantial revision of the first edition The topics

cov-ered are as dynamic as the alternative investments industry itself, as every textbookunderlying the CAIA program adapts to growth in the industry and emerging assettypes Although the private equity and hedge fund parts closely follow those of theprevious edition, material on managed futures, commodities, and real estate has beensubstantially revised Across most topic areas, coverage on due diligence, liquidityrisk, and operational due diligence has been enhanced The importance of currencymarkets in global investing is directly addressed in a commodity context as well aswithin the framework of global macro hedge funds

1 1 O U T L I N E O F T H I S B O O K

The book is divided into five parts The first part discusses endowments, tions, and pension plans as examples of institutional investors The final four partseach discuss a sector of alternative investment strategies: private equity, real assets,commodities, and hedge funds and managed futures

founda-Part One of the book discusses asset allocation and portfolio management fromthe point of view of institutional investors Completely new to the second editionare Chapters 2, 3, and 4, which outline the investment challenges and practices

of endowments, foundations, and pension plans, which have become some of theworld’s largest investors in alternative assets These chapters explore the motivationfor those investors to grow their asset allocation to alternative investments They facespecial risks and considerations when investing in alternative assets and integratingthose assets into their business operations These include spending rates, inflation,liquidity, rebalancing, tail risk, funding status, and surplus risk The endowmentmodel as represented by the investment strategy of Yale University’s endowment isexamined in Chapter 2, while liability-driven investing is a highlight of Chapter 4.Part Two, which comprises Chapters 5 to 14, discusses the private equity mar-

ket Building on the material from CAIA Level I: An Introduction to Core Topics in

Alternative Investments, it covers advanced topics in private equity investments and

describes various routes into those investments It explains manager selection andmonitoring processes; reviews benchmarking in the private equity world, valuationmethods, and management of liquidity; explains substrategies of private equity, in-cluding buyouts, venture capital, and mezzanine financing The roles of the general

1

Part Three presents real assets, including real estate, farmland, timber, and tellectual property investments Real assets are considered desirable assets because

in-of their potential to provide a hedge against inflation risk Three chapters in this tion, Chapter 16: Unsmoothing of Appraisal-Based Returns, Chapter 21: Farmlandand Timber Investments, and Chapter 22: Investing in Intellectual Property, are new

sec-to this edition The Level I book discussed real estate investments in terms of theunderlying equity or debt structure This book divides real estate into publicly tradedand private partnership investments, as well as risk characterizations including in-vestments in core, value-added, and opportunistic properties Various forms of realestate investment and valuation methodologies are discussed, as is the due diligence

of real estate investments and the risk-return characteristics of major real estateindices Of special interest is Chapter 16, which contains all-new material on the un-smoothing of real estate returns Illiquid assets tend to have return processes that aretoo smooth, which leads to biases in their risk estimation Because appraisal-basedreturns, whether in real estate or in private equity, are not what they seem, investorsneed to make quantitative adjustments to smoothed returns to calculate more accu-rate risk exposures before adding these investments to their portfolios Reflecting themarket’s dramatic growth in real asset investments, Chapters 21 and 22 have beenadded to discuss investments in farmland, timber, and intellectual property

Part Four discusses commodities with a focus on commodity investments throughfutures and swaps markets The role of hedgers and speculators is explored, alongwith how each might impact the term structure of futures prices The readings provideadvanced analysis of commodity markets and explain the role of commodities in assetallocation This part describes various methods for generating commodity alpha andbeta through spot and futures transactions and discusses major commodity indicesand their risk-return profiles The role of fundamental demand and supply factors

is explored, as well as the financial market drivers of commodity returns, includinglinkages to currency markets, interest rates, inflation, and the business cycle Riskmanagement of commodity strategies is also included, with studies in liquidity riskand event risk management

The final section, Part Five, discusses hedge funds and managed futures The firstfour chapters, 29 to 32, cover managed futures strategies The structure of the man-aged futures industry and its regulatory framework are presented, and each managedfutures strategy and its risk-return profile are explained The role of managed fu-tures in diversified portfolios is examined, and performance evaluation and managerselection processes are explained The distinctions between single-manager and mul-timanager funds, separate accounts, and platform investments are discussed, whichcan have important implications for performance, fees, and legal risks In light of thecollapse of MF Global, the importance of collateral segregation is emphasized Riskmeasurement and control are presented, and the importance of margin-to-equityratios is discussed

Finally, Chapters 33 to 40 discuss investments in hedge funds New to this tion is Chapter 33, which explores the theory and practice of hedge fund replication