CFA level 3 study notebook4 2015

Study Session 13Cross-Reference to CFA InstituteAssigned Reading #25 -Alternative Investments Portfolio Management E 7?. Study Session 13Cross-Reference to CFA InstituteAssigned Reading

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BOOK 4 - ALTERNATIVE INVESTMENTS,

StudySession13- Alternative Investments for PortfolioManagement 8

StudySession15-Risk Management Applications ofDerivatives 89

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SCHWESERNOTES™2015 CFALEVELIII BOOK4:ALTERNATIVEINVESTMENTS, RISK MANAGEMENT, ANDDERIVATIVES

Publishedin2014 by Kaplan,Inc

Printedinthe UnitedStatesofAmerica

ISBN:978-1-4754-2786-8/1-4754-2786-7PPN:3200-5565

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was

distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation

of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy

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Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level I, II, and III questions fromCFA®

These materials may not be copied without written permission from the author The unauthorized

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Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth

by CFA Institute in their 2015 CFA Level III Study Guide The information contained in these Notes

covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.

However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes.

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READINGS AND

READINGSThefollowing materialisa reviewofthe AlternativeInvestments,RiskManagement,and

Derivativesprinciples designedtoaddress the learningoutcome statements setforthby CFA

Institute

STUDY SESSION 13

ReadingAssignments

AlternativeInvestmentsfor PortfolioManagement, CFAProgram2015Curriculum,

Volume5,LevelIII

25 AlternativeInvestmentsPortfolio Management page 8

STUDY SESSION 14

ReadingAssignments

Risk Management, CFA Program 2015Curriculum,Volume5,Level III

STUDY SESSION 15

ReadingAssignments

RiskManagementApplicationsofDerivatives,CFAProgram2015Curriculum,

Volume5,LevelIII

27 Risk Management Applications of Forward andFuturesStrategies

28 Risk Management Applications of Option Strategies

29 RiskManagementApplications of Swap Strategies

page89page116page 164

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Book4—Alternative Investments, Risk Management,andDerivatives

Readingsand Learning Outcome Statements

LEARNINGOUTCOME STATEMENTS(LOS)The CFAInstitutelearningoutcome statementsarelistedinthefollowing Thesearerepeated

ineachtopicreview However, the order may have been changedinorderto getabetterfit

with theflow ofthereview.

STUDY SESSION 13

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

25 AlternativeInvestments PortfolioManagementThe candidate should be ableto:

a. describecommonfeatures of alternativeinvestmentsand their markets andhow alternativeinvestments maybe grouped by the role they typically playina

among the principal classes of alternativeinvestments,includingreal

estate,private equity, commodityinvestments,hedgefunds,managedfutures,buyoutfunds,infrastructurefunds,and distressedsecurities,(page11)

e. discuss theconstructionand interpretation of benchmarks and the problem ofbenchmark biasinalternativeinvestmentgroups,(page16)

f evaluatethereturnenhancement and/or risk diversificationeffects of addinganalternativeinvestmentto areference portfolio(forexample,aportfolio investedsolelyincommonequity andbonds),(page20)

g describeadvantages and disadvantages of direct equityinvestments in realestate.

(page24)

h discussthe majorissuersand suppliers ofventurecapital, thestagesthroughwhich private companies pass(seedstagethroughexit),the characteristicsources

of financingateachstage,and thepurposeof such financing, (page25)

i compareventurecapital funds and buyoutfunds,(page26)

j discusstheuseof convertible preferred stockindirectventurecapital

m. compareindirect and direct commodityinvestment,(page28)

n. explain the threecomponentsofreturnforacommodity futurescontractandtheeffect thatanupward-ordownward-slopingterm structureof futures priceswill haveonroll yield, (page28)

d

essuggested for commoditiesinaportfolio and explainwhysomecommodity classesmayprovideabetterhedgeagainst inflation thanothers,(page29)

p identify andexplain the style classification ofahedgefund,givenadescription

ofits investmentstrategy,(page30)

q discuss the typicalstructureofahedgefund,including the feestructure,andexplain the rationale for high-water mark provisions, (page32)

o.

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Book4—AlternativeInvestments, RiskManagement, andDerivatives

Readingsand LearningOutcomeStatements

r. describe the purpose and characteristics of fund-of-funds hedgefunds,(page33)

s. discussconcernsinvolvedinhedge fundperformanceevaluation,(page33)

t. describetrading strategies of managed futuresprogramsand the role of managed

futuresinaportfolio, (page35)

u describe strategies and risks associated with investingindistressedsecurities

(page37)

v. explaineventrisk,market liquidityrisk,marketrisk,and“J-factorrisk”in

relationtoinvestingindistressedsecurities,(page38)

STUDY SESSION 14

26 RiskManagement

The candidate should be ableto:

a. discussfeatures of the riskmanagementprocess, riskgovernance,riskreduction,

andanenterprise riskmanagement system,(page51)

b evaluate strengths and weaknesses ofacompany’s riskmanagementprocess

(page52)

c. describestepsinaneffective enterprise riskmanagement system,(page52)

d evaluateacompany’sor aportfolio’sexposurestofinancial and nonfinancial risk

factors,(page53)

e. calculateandii andexplainitsroleinmeasuring

overall and individual position marketrisk,(page55)

f comparetheanalytical(variance-covariance),historical,andMonteCarlo

methods for estimating VAR and discuss theadvantagesand disadvantages ofeach,(page56)

g discussadvantages and limitations of VAR anditsextensions,including cash

flowatrisk,earningsatrisk,and tail valueatrisk,(page60)

ve typesofstresstesting and discussadvantages andh

disadvantagesofeach,(page61)

i evaluatethe credit riskofan investmentposition, including forwardcontract,

swap, and option positions, (page63)

j demonstrate theuseof risk budgeting, positionlimits,and other methods for

managing marketrisk,(page68)

k demonstratetheuseofexposure limits,markingtomarket, collateral,netting

arrangements,creditstandards,and credit derivativestomanage credit risk

(page69)

1 discuss the Sharperatio,risk-adjustedreturn oncapital,returnovermaximum

drawdown,and theSortino ratioasmeasuresof risk-adjusted performance

(page71)

m demonstratetheuseof VAR andstresstestinginsettingcapital requirements

(page72)

STUDY SESSION 15

27 Risk Management Applications of Forward andFuturesStrategies

The candidate should be ableto:

a. demonstrate theuseof equity futurescontracts toachievea targetbetafora

contracts

stock portfolio andcalculateandirequired, (page89)

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Book4—Alternative Investments, Risk Management,andDerivatives

b construct asynthetic stock index fund using cash and stock index futures(equitizingcash),(page93)

c. explain theuseof stock index futuresto convert along stock positionintosyntheticcash,(page98)

d demonstrate theuseof equity and bond futurestoadjust the allocation ofa

portfolio between equity anddebt,(page99)

e demonstrate theuseof futurestoadjust the allocation ofaportfolioacross

equitysectorsandtogainexposuretoanassetclassinadvanceof actuallycommitting fundstotheasset class,(page102)

f explain exchangeraterisk anddemonstratetheuseof forwardcontracts to

reduce the risk associated withafuture receiptor paymentinaforeigncurrency

(page104)

g explain the limitationstohedging the exchangerateriskofaforeign marketportfolio and discuss feasible strategies for managing suchrisk,(page107)

Thetopicalcoveragecorresponds with thefollowingCFA Instituteassigned reading:

28 RiskManagementApplicationsofOption StrategiesThe candidate should be ableto:

a. compare theuseof covered calls and protectiveputs tomanage riskexposureto

individualsecurities,(page122)maximum loss,breakeven underlying priceatexpiration, and generalshape ofthe graph for the following option strategies: bull spread, bear spread, butterflyspread,collar, straddle,box spread, (page127)

rateforagiveninterestrate outcomewhena

borrower(lender)manages the risk ofananticipated loan usingan interestratecall (put) option, (page140)

d calculate thepayoffs foraseriesofinterestrate outcomeswhenafloatingrate

loaniscombined with1)aninterestratecap, 2)aninterestratefloor,or3)an

interestrate collar,(page146)

e. explain why and howadealer delta hedgesanoption position, why deltachanges, and how the dealer adjuststomaintainthe delta hedge, (page152)

f interpret thegammaofadelta-hedged portfolio and explain howgammachangesasin-the-money and out-of-the-money optionsmovetoward expiration

(page156)c

29 Risk Management Applications of Swap StrategiesThe candidate should be ableto:

a. demonstrate howan interestrateswapcanbe usedto convert afloating-rate(fixed-rate)loanto afixed-rate (floating-rate)loan,(page164)

b

c. explain the effect ofan interestrateswap on anentity’s cash flow risk

(page167)

d determinethe notional principal value neededon aninterestrateswapto

achieveadesired level of durationinafixed-income portfolio, (page168)

e. explain howacompany cangeneratesavings by issuingaloanorbondin itsowncurrencyand usingacurrencyswapto convertthe obligationintoanothercurrency,(page172)

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Book4- Alternative Investments, Risk Management,andDerivatives

f demonstrate howafirmcan use acurrencyswapto convert aseriesof foreign

cashreceiptsintodomesticcashreceipts,(page173)

g explainhow equity swapscanbeusedtodiversifyaconcentrated equity

portfolio, provideinternationaldiversificationto adomestic portfolio, and alterportfolio allocationstostocks andbonds,(page174)

h demonstrate theuseofaninterestrateswaption1) tochange thepayment

patternofananticipatedfuture loan and2) to terminate aswap,(page177)

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The following is a review of the Alternative Investments for Portfolio Management principles designed to

address the learning outcome statements set forth by CFA Institute This topic is also covered in:

ALTERNATIVE INVESTMENTS PORTFOLIO

MANAGEMENT1

Study Session 13

EXAMFOCUSThis topicassignmentprovidesanoverviewofmajortypesofalternative investmentsand their rolesinportfolioconstruction Bepreparedfor questionsrelatingto:

1) commonelementsand differencesamongalternativeinvestments; 2) availablebenchmarks andmeasurementchallenges;3)strategies and role in theportfolio; and4)

due diligenceissues.Thisisqualitative materialso expectquestions focusingonrecallandunderstandingconcepts.

ALTERNATIVEINVESTMENT FEATURES

LOS25.a:Describecommonfeatures of alternativeinvestmentsandtheirmarkets and how alternativeinvestmentsmay begroupedby the role they

typically playinaportfolio.

CFA®ProgramCurriculum,Volume5,page7Alternativeinvestmentsofferdiversificationbenefitsandthepotentialforactive

management.Thereare sixbasic groups Traditional alternativeinvestmentsinclude real

estate,private equity,and commodities Themoremodern alternativeinvestmentsincludehedgefunds,managedfutures,and distressedsecurities.

Alternativeinvestmentscanalso be grouped by their roleinportfoliomanagement:

1. Realestateand long-only commoditiesoffer exposuretoriskfactorsandreturnthatstocks and bondscannotprovide

2 Hedgefunds andmanagedfuturesofferexposuretospecialinvestmentstrategies and

areheavily dependentonmanager skill

3 Privateequityand distressedsecuritiesare seen as acombinationof1and2

1 Theterminologyusedthroughoutthis topic review is industry convention aspresentedinReading 25ofthe2015CFA LevelIIIexam curriculum.Empiricalresults are referenced inthat readingas well.

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StudySession 13 Cross-Reference to CFA InstituteAssigned Reading #25 -Alternative Investments Portfolio Management

Alternativeinvestmentscanbe highly unique and therearedifferencesof opinionon

howtogroupthem.Butthey do sharesome commonfeatures:

1. Low liquidity Their general lack of liquidity requires carefulattentiontodetermine

if theyaresuitableforagiveninvestor.The alternativeinvestmentshould also be

associated withaliquidity premium and higherreturn.

2 Diversification.They generally have low correlation with and offer significant

diversificationtotraditional stock and bond portfolios

3 Due diligencecosts.Costsassociated with researching and monitoring alternative

investmentscanbehigh.Specialized expertise and specific business skillsareoften

required These markets frequently lacktransparency,making information difficult

toobtain

4 Difficultperformance evaluation The lack oftransparencyand unique features of

manystrategies makeitdifficulttoidentify appropriate valuation benchmarks

DUEDILIGENCECHECKPOINTS

LOS25.b: Explainand justifythe major duediligence checkpointsinvolvedin

selectingactive managersof alternativeinvestments

CFA®ProgramCurriculum,Volume5,page10The lackoftransparencyand unique strategies ofmanyalternativeinvestmentmanagers

makes due diligenceinmanager selection crucial:

1 Assessthe market opportunityoffered.Arethere exploitable inefficienciesinthe market

for thetypeofinvestments inwhich the manager specializes? Pastreturnsdonot

justifyselectingamanager unless thereareunderstandable opportunities available

for the managertoexploit.(This onewould have stoppedanyonefrom investing

withBernie Madoff.)

2. Assesstheinvestmentprocess.Whatisthemanager’scompetitiveedgeoverothersin

that market?Howdoes themanager’sprocess identifypotential opportunities?

3 Assess theorganization.Isitstable and wellrun?What has been the staffturnover?

4 Assess the people.Meetwith them andassesstheircharacter,both integrity and

competence.

5 Assessthetermsandstructureoftheinvestment.Whatisthefeestructure?Howdoes

italign theinterestof the manager with theinvestors?Whatisthe lock-out period?

Many funds donotallow withdrawalsforaninitial period Whatistheexitstrategy

for redeeming the funds invested?

6 Assesstheserviceproviders Investigate the outside firms thatsupportthemanager’s

business (e.g., lawyers,brokers,ancillarystaff)

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Study Session 13

Cross-Reference to CFA InstituteAssigned Reading #25 -Alternative Investments Portfolio Management

E 7 Reviewdocuments.Reviewtheprospectusorprivate-placementmemorandum,the

audits of the manager’sreports,and other available documents Seek legal and other

expertadvice where needed

8 Write-up.Documentthe abovereviewprocess

ISSUESFOR PRIVATEWEALTH CLIENTS

LOS 25.c:Explaindistinctiveissuesthat alternativeinvestments raiseforinvestment advisersof private wealth clients

CFA®Program Curriculum, Volume5,page11

Institutionalinvestorsarepresumedtobemoreknowledgeable and dispassionateinvestors.Individualscanbe lessknowledgeable,more emotional,andhave realissuesthatmustbe consideredtodeterminesuitability

Taxes Mostindividualsmustpaytaxes.Many alternativeinvestmentsarestructured

aslimited partnerships which require specializedtaxexpertise

1

2 Suitability Many alternativeinvestmentsrequire that fundsstayinvestedfora

minimum timeperiod.Isthis compatible with the investor’stimehorizon andliquidity needs? What happens if theinvestor’s situationchanges? Individualsmayhave emotional feelings that draw them towardsorrepel them fromsome

investments

3 Communication.Discussingcomplex strategies with the clientisnoteasy.When

aclientisexcited aboutaunique opportunity, how doyoumakesurethey really

do understanda ten-yearlock-outmeanstheycannot getthemoneybackforten

years?Howdoyouexplain the diversification benefit ofaverycomplexstrategy to

someonewithnoinvestmenttraining?

4 Decisionrisk This could be definedasthe riskof emotionally abandoninga strategy

rightatthe point ofmaximumloss Carefully communicating the expectedupsanddowns ofa strategyand being prepared for the emotionalresponsetothe downside

ishard Some strategies offer frequent smallreturnsbut the occasionallargeloss

Theymaximizethe chanceofanemotionalinvestormaking the wrong decisiontocashoutafteraloss Other strategies offer wild swings between large gains and losseswithan attractivelongtermaveragereturn.

5 Concentratedpositions Wealthy individuals’ portfolios frequentlycontainlargepositionsinclosely heldcompanies orprivate residences Suchownership should

be consideredas apreexisting allocation beforedecidingtoadd additional privateequityorrealestateexposure These existing positionsmayalso have large unrealizedtaxable gains which add complexitytoanyrebalancing decision

Oneapproachtoincorporating alternativeinvestments intoatraditional portfoliois

core-satellite The traditionalcoreof the portfolio wouldremainasstocks and bondsto

provide market exposure andreturn However,it isdifficulttoadd valueinsuch efficientmarkets.Moreinformationally inefficient alternativeinvestmentswould be addedto

provideexcess return(alpha)asthe satellite

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ALTERNATIVE INVESTMENTCLASSES

LOS 25.d:Distinguishamong theprincipalclassesof alternativeinvestments,

includingrealestate,private equity, commodityinvestments,hedgefunds,

managedfutures,buyoutfunds,infrastructurefunds,and distressedsecurities

CFA®ProgramCurriculum,Volume5,page13

Professor’sNote: YoumightnoticetheCFAtextjustswitchedfromsixgroupstoeight classes Thatisbecauseinfrastructurefundsareasubgroupofrealestate

andbuyoutfunds ofprivate equity

Real Estate

Onewaytoclassify realestateinvestment isbetweendirect and indirect.Directrealestate

investmentincludes ownership ofresidences,commercial realestate,oragricultural land

The ownership involves directmanagementof theassets.Indirectinvestment inreal

estategenerallymeansthereisawell-defined middlegroupthatmanagesthe properties

Indirect realestateinvestmentsinclude:

• Companies thatdevelop andmanagerealestate.

• Realestateinvestmenttrusts (REITs),whicharepublicly traded equity sharesina

portfolio of realestate.Equity REITSownandoperateproperties whilemortgage

REITSholdmortgagesonrealestate.REITScan be purchasedinsmallsizesandare

liquid

• Commingled realestatefunds(CREFs),whicharepooledinvestments inrealestate

thatareprofessionally managed and privatelyheld,havemoreflexibility thanREITs

Theycanbe open-end and allowinnew investorsorclosed-end andnotallowin

new investorsafteraninitial offering period Theyarerestrictedtowealthyinvestors

andinstitutions

• Separately managedaccountsfor wealthyinvestorsareusually offered by thesame

managers who manage CREFs

• Infrastructure funds specializeinpurchasing public infrastructureassets

(e.g., airports, tollroads)fromcities, states,and municipalities.Because

infrastructureassetstypically provideapublicservice,they tendtoproduce relatively

stablelong-termreturns.They tendtoberegulatedby localgovernmentswhich adds

tothe predictability of cash flows Their low correlation with equity marketsmeans

infrastructureassetsprovidediversification,and their long-termnatureprovidesa

good match forinstitutionswith long-term liabilities (e.g., pensionfunds).Their

relatively lowrisk, however,meansthat infrastructurereturns arelow

The advantages of realestateinvestmenttypically include low correlation with stocks

and bonds (providingaportfolio diversificationbenefit),low volatility ofreturn,and

oftenaninflation hedge Realestatemayalsooffertaxadvantages and the potentialto

leveragereturn.

Disadvantages include high information andtransactioncosts,political risk relatedto

the potential fortaxlaw changes, high operating expenses, and the inabilitytosubdivide

directinvestments.Realestate asanassetclass and each individual realestate assetcan

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institutions Often,the investingisdone through pooling funds with otherinvestors

inaprivate equity fund Thereare numeroussubcategoriesof private equity Thetwo

mostimportantareventurecapital, which provides fundingto startorgrowaprivatecompany, and buyoutfunds,which provide fundstobuy existing public companiesfrom their shareholders and then take thecompanyprivate

Two importantsegmentsof buyout fundsaremiddle-market buyoutfundsandmega-capbuyoutfunds.Middle-market buyout fundsconcentrate ondivisionsspunoff from larger,publiclytraded corporations and privatecompanies that,duetotheir relatively small

size, cannotefficiently obtain capital Mega-cap buyout fundsconcentrateontakingpublicly traded firms private

Buyout funds add valuethroughsomecombinationof:1)restructuringcompanyoperations andmanagement,2)buying companies for less thanintrinsic value,and

3)creating value by addingleverageorrestructuring existing debt of thecompany.Theexitstrategies includeselling the companies throughprivateplacementsorIPOsorthrough dividend recapitalizations.Inadividend recapitalization, the company(underdirectionof the buyoutfund) issuessubstantial debt and paysalarge special dividend

tothe buyout fund and other equityinvestors.The debt effectively replacessome or

mostof the equity of thecompany,whileallowingtheinvestorstorecoup some orall oftheir originalinvestment.Recapitalizationincreasesthecompany’sleverage but doesnot

change theowner.Thebuyout fundretainscontrol butextractscashfrom the company

Privateequityisahighly diverse class that typically involves high risk withasignificantnumberofinvestmentsthat fail Theventurecapitalistisoften expectedtobringnot

only funding but business expertiseto operatethecompany.Theentrepreneurswhostartthe company often lack the capital andmanagementskillstogrow the company

The companymayemployagents tosolicit private equityinvestorsthroughaprivateplacement memorandum which describes the business plan,risk,andmanyother details

of theinvestment

CommoditiesCommodityinvestmentscaninclude direct purchase of the physical commodity(e.g., agricultural products, crudeoil, metals) orthe purchase of derivatives(e.g.,futures) onthoseassets.Indirectinvestment incommoditiescanincludeinvestment incompanies whoseprincipal businessisassociated withacommodity(e.g., investinginametalviaownership of sharesinaminingcompany).Directinvestmentthrough derivativesismore common asindirectinvestmenthasnottrackedwell with commodity price changes and directinvestmentby buying the commodities

createsissuestoconsider suchas storage costs.

Investments inboth commodity futures and publicly traded commodity companiesarefairly liquid, especially when comparedtomanyother alternativeinvestments

Investments incommodities havecommon riskfeatures suchaslow correlation with

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stocks and bonds and business-cyclesensitivity,andmosthaveapositivecorrelation

withinflation.These risk characteristicsarethereasonscommodities provide good

diversificationtoan investor’sportfolio

HedgeFunds

Hedge fundsareadiversegroupand theterminology usedtodescribe themisflexible

Initially theywereprivatepools ofmoneythatwereboth long and short the market

Hence,theywerenotexposedtomarket risk Many hedge funds stilltargetanabsolute

levelofreturnthatisnotdependentonmarketreturns.Hedge fundsaregenerally

structuredtoavoid regulation which also allows themtocharge substantialincentive

fees Each fundisdesignedtoexploitaperceived market opportunity, oftentakingboth

long and short positionsonaleveraged basis Many hedge funds describe themselvesas

exploiting arbitrage opportunities.In thecaseof hedge funds theterm“arbitrage”isused

verylooselyto meanlower-risk andnot to meanrisk-free

Hedge fund classifications include: equity marketneutral,convertible arbitrage,

fixed-incomearbitrage, distressedsecurities, mergerarbitrage, hedged equity, globalmacro,

emergingmarkets,andfund of funds(FOF)

Professor’sNote: Foradiscussionoftheseterms seeLOS 25.p

ManagedFutures

Managed futures fundsaresometimesclassifiedashedge funds Others classify them

as a separatealternativeinvestmentclass In the UnitedStates,theygenerallyusethe

samelimited partnership legalstructureand basefee plus performance fee compensation

structure ashedge funds A2%basefee plusa20%shareof the profitsisacommonfee

structure.Like hedgefunds,theyareoften consideredtobe skill based andnot an asset

class, perse;theydependonthe skillof themanagertofind andexploit opportunities

andassuch havenoinherentreturnand risk characteristicsof theirown

Theprimaryfeature that distinguishes managed futures from hedge fundsisthe

differenceintheassetsthey hold.Forexample, managed futures funds tendtotradeonly

inderivativesmarkets,while hedge funds often tradeinspotandfutures markets.Also,

managed futures funds generally take positions basedonindices,while hedge funds tend

tofocusmoreonindividualassetprice anomalies In otherwords,hedgefunds tendto

havemoreofamicro focus,while managed futures tendtohaveamacrofocus.In some

jurisdictions theyare moreregulated than hedge funds

Investment inmanaged futurescanbe done through: private commodity pools, managed

futuresprogramsasseparately managedaccounts(calledCTAmanagedaccounts),and

publicly traded commodityfuturesfundsthatareavailabletosmallinvestors.Liquiditywill

be lowerfor private funds than for publicly traded commodity futures funds

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Study Session 13

E Tradingstrategiesandclassificationsused include:

• Systematictradingstrategies follow rules Trendfollowingrulesarecommonandmayfocuson short-, medium-, orlong-term trends.Contrarianstrategiesexistbutareless

common.

• Discretionarytradingstrategiesdependonthe judgment of themanagerand could bebasedoneconomic orothercriteria

• Managed futuresmay invest inallfinancialmarkets, currencymarketsonly,ora

diversifiedmixof derivatives and underlying commodities

The risk characteristicsofmanagedfutures willvary,asthey do forhedgefunds.Atrend¬

followingstrategywilloffer lower diversification thanacontrarianstrategy.The standarddeviationof managed futuresisgenerally less than that of equities butgreaterthanthat of bonds The correlation between managed futures and equitiesislow and oftennegative Withbonds,the correlationishigherbut still less than 0.50

DistressedSecuritiesDistressedsecuritiesaresecuritiesof companies thatareinor nearbankruptcy Theyare

anothertypeof alternativeinvestmentwhere the risk andreturndependuponskill-basedstrategies Some analysts consider distressedsecuritiestobepartof the hedge fund class

orof the private equity class

Onewayto constructsubgroupsindistressedsecurities isbystructure,which determinesthe levelof liquidity The hedge fundstructurefor distressedsecurity investment ismore

liquid The private equity fundstructuredescribes funds thatareless liquid because theyhaveafixedtermandareclosed-ended The latterstructureismoreappropriate whenthe underlyingsecuritiesaretooilliquidtoovercomethe problem of determininga net assetvalue(NAY)

Figure1 presents asummaryof alternativeinvestmentcharacteristics

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StudySession 13 Cross-Reference to CFA InstituteAssigned Reading #25- Alternative Investments Portfolio Management

Figure1 :AlternativeInvestmentCharacteristics

TypesofInvestments Risk/Return Features Liquidity

Real estate Residences; commercial

real estate; raw land.

Largeidiosyncraticrisk

component;providesgooddiversification.

middle-risk and lower returns

than investments in

established companies

via buyout funds.

Less risk than venture

capitalfunds;good

diversification.

Buyout funds Well-establishedprivate

firms and corporate

spin-offs.

Public infrastructureassets.

Low.

Commodities Agriculturalproducts;

crudeoil; metals.

Risk is between that

of equities and bonds.

Negativeandlow correlations with equities and low-to-moderate correlations with bonds.

Lower for private funds than for

publicly traded

commodity futures funds.

Distressed

securities

May be part ofhedgefundclass or private equity class Investments higherreturns due to

can be in debt and/or equity.

Dependsonskill-based

strategies Can earn

Hedge fund

structure moreliquid;private equity structure less

Forthe Exam: The varioustypesof alternativeinvestmentclasses appear in

severalplaces throughoutthecurriculum Hedge fundsinparticulararediscussed

severaltimesandrealestatereceivesmorecoveragethansomeofthe other topics

Commoditiesareexaminedingreaterdetail laterinthis studysession.Youwill be

abletofind small inconsistencies in the discussionssofocusonthemainpoints of

agreementandbeawareofareasthat may bemorecontroversial Thepublishedtopic

weight for alternativeinvestmentsis5-15%

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Study Session 13

LOS 25.e:Discusstheconstructionand interpretation of benchmarks and the

problemof benchmark biasinalternativeinvestmentgroups

CFA®ProgramCurriculum, Volume5,page 15

FortheExam: Bereadytodiscuss the general properties, including thedrawbacks,ofalternative investment benchmarks

Appropriate benchmarks foragivenalternative investment managercanbe difficultto

establish Thefollowinglist describes themore common benchmarks available andsome

of the issues thatarise.

• Realestatehas the National CouncilofRealEstate InvestmentFiduciaries

(NCREIF)Property Indexas itsprincipalbenchmarkfor directinvestments.TheNCREIFIndexis avalue-weighted indexofcommercially ownedproperties thatuses

samples based bothongeographic location andtype(e.g.,apartmentandindustrial).

The valuesareobtained periodically, usually by annual appraisal,sothe volatility oftheindexisdownwardbiased Theindex ispublished quarterly

Forindirect realestate investment,the primary benchmarkisthe NationalAssociationof RealEstate InvestmentTrusts(NAREIT)Index.TheNAREIT Index

iscap-weightedandincludesallREITs tradedonthe NYSEorAMEX.Similar

tootherindices based uponcurrenttrades, themonthlyNAREITIndexis“live”

(i.e.,itsvaluerepresents current values).

The biggest problemistheinfrequent tradingofmost realestateinvestmentsandtheresulting understatementofactual volatility.Varioustechniqueshave beenusedto unsmoothor“correct” this bias The unsmoothed dataraisesthe standarddeviation and reduces the Sharperatioof realestate,making realestatelessattractivebut stillavaluable additiontostock and bond portfolios duetoitslow correlation

Anotherproblemisthat many realestateindicesreflectleveragedinvestments.

When leverageeffectsareremoved,returnsand Sharperatiosarelower,butthelowcorrelation with otherassetclasses still leaves realestate as anattractiveadditionto

portfolios Finally,in thecaseofREITS, thereturns are morecorrelated with equitywhile othertypesof realestate investment areless correlated with equity, meaningREITSoffer less ofadiversification benefit

• Privateequity indicesareprovided by CambridgeAssociatesandThomsonVentureEconomics.Indicesareconstructedfor thebuyout andventurecapital

(VC) segmentsof the private equitymarkets.Because private equityvaluesare not

readilyavailable,the valueofaprivateequity indexdependsuponeventslikeIPOs,

mergers,newfinancing, andso on toprovide this information.Thus,the indicesmightpresentdated valuesasrepricing occursinfrequently.Notethatprivateequity

investorsalsooftenconstruct custombenchmarks

The primary problemsarethe lackof pricingdata,forcingaheavy relianceon

appraisal valuesforinvestments,and theresulting smoothingofreturnsandunderstatementofvolatility.In addition, private equityshowsa strongvintageyear

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effect Theeconomicconditionsof theyear inwhich the fundwaslaunched have

asignificant effectonsubsequentperformance for thelifeofthefund.Asaresult,

comparisonsareoften madetoother funds launched in thesameyear

• Commodity markets havemanyindicesforuse asbenchmarks.Mostof them

assume afutures-basedstrategy.Forexample,theDowJones-UBSCommodity

Index (DJ-UBSCI)andthe S&PCommodity Index(S&PCI) represent returns

associated withpassivelongpositions infutures

Theindicesinclude exposuresto most typesof commoditiesandareconsidered

investable.Theycanvarywidely,however, withrespect totheir purpose,

composition,and methodofweighting theclasses Given the zero-sumnatureof

futures,the indicescannot use amarket-cap method of weighting Two methods of

weightingare 1) basing weightsonworld production of the underlying commodities

and2)basing weightsontheperceivedrelativeworldwideimportance of the

commodity.The variousindicesuseeither arithmeticorgeometric averagingto

calculatecomponent returns.

Professor’sNote:Although thereareother characteristicsanindexmust meet

tobe consideredinvestable,theeasiestwaytolookat it iswhetheraninvestor canactually hold the index by purchasing all theassetsin the indexinthesame

weightsasin the index Forexample,an investor canpurchaseand holdall thestocksoftheS&P500.Ifthatcannotbedone, theindexis notinvestable

• Managed futures have several investable benchmarks.Somecommonbenchmarks,

suchastheMount LucasManagement Index(MLMI),replicate thereturn to a

mechanical, trend-followingstrategy.The strategiesusuallyincludeutilizingboth

long andshort positions usingtrading rules baseduponchangesin technical

indicators.Other benchmarks,suchastheCTAIndices published bytheCenter

for InternationalSecuritiesandDerivativesMarkets(CISDM),areindices based

uponpeer-group managedfuturesfunds.Theycan usedollar-weighted(CTA$) or

equal-weighted (CTAEQ)returnsfromdatabasesofseparately managedaccounts.

Amongtheseindicestherearebenchmarksbasedupon the levelof discretionary

managementand the underlyingmarket,aswellastrend-followingorcontrarian

• Distressedsecuritiesfundsareoften consideredahedge fund subgroup.Most

of the indexprovidersforhedgefunds haveasub-indexfor distressedsecurities.

Benchmarks in thisareahave thesamecharacteristicsaslong-only hedge fund

benchmarks

Figure 2presents asummary of these alternativeinvestment benchmarks,their

construction,andtheirassociated biases Hedge fundbenchmarksarethendiscussed

separately

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Study Session 13

I Figure2:AlternativeInvestmentBenchmarks

Real estate NCREIF isvalue weighted;

NAREIT is capweighted

Measured volatilityis

downward biased The values are obtained periodically (annually).

Repricing occursinfrequentlywhich results in dated values.

NCREIF; NAREIT.

ProvidedbyCambridge

Associates and Thomson Venture

Economics.

Constructedfor buyout and venturecapital.Value

dependsupon events.

Often construct custom

benchmarks.

Private equity

strategy Most types

considered investable.

Indices vary widely with respect to purpose, composition, and method

MLMIreplicatesthe

return to atrend-followingstrategy CTAIndicesusedollar-weightedorequal-weightedreturns.

Weightingeitherequallyweightedor based upon

assets under management.

Selection criteria can vary.

MLMI; CTA Indices.

Distressed

securities

Characteristics similar tolong-

onlyhedge fund

company.The followingpoints summarizethewaysindex providerscompose theirrespective indices

• Selection criteriacanvary,and methods includeassetsundermanagement,the length

of the trackrecord,and therestrictionsimposedon newinvestment

• Styleclassificationalsovariesas tohow they classifyafund by style and whetherit isincluded inagiven index

• Weighting schemesareusuallyeitherequally weightedorbaseduponassetsunder

management.

• Rebalancing rulesmustbe definedfor equally weightedindices,and thefrequency

canvaryfrom monthlytoannually

• Investabilityoftendependsuponfrequencyof reporting(e.g., dailyreportingallowsforinvestability while monthlyreportingtendsnot to).Someindicesare

notexplicitlyinvestable,but independent firms modify the indextoproducean

investable proxy

Someindices explicitlyreportthe funds they includeinthecomposition of the index,andsomedonot.Someindicesreportmonthly andsome reportdaily Examples ofproviders of daily indicesareHedge Fund Research(HFR),DowJones(DJ),and

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Standard&Poor’s(S&P).TheDJand S&P explicitly list the funds includedintheir

indices anduse anequal-weightingapproach

The following lists providers of monthly indices withafew of their general characteristics:

• CISDMofthe UniversityofMassachusetts: several indices thatcoverboth hedge funds

and managed futures (equally weighted)

• CreditSuisse/Tremont:providesvariousbenchmarksfor different strategies andusesa

weighting scheme baseduponassetsundermanagement.

• EACMAdvisers: provides theEACM100®Index, anequally weighted index of100

fundsthat spanmanycategories

• Hedge Fund Intelligence, Ltd.: providesanequally weighted index ofover50 funds

• HedgeFund.net:providesanequally weighted indexthatcovers morethan 30

strategies

Hedge fund benchmark selection includes severalissues:

• Relevanceofpastdatamaybe questionable If hedge fundsareareflectionof

managerskill,thenpast returnsfor indicesisless relevanttofuturereturnssince

hedge fund indices frequently change composition and thusmanagerswithin the

index The empirical evidence shows that funds withinaparticular style do have

similarreturnsandthatindividual managers donotconsistently beat their style

group The data alsosuggestsvolatility ofpast returnstendstopersistevenwhen

returndoesnot.This makes selectionof the relevant comparison benchmark very

important

• Popularitybias canresult ifoneof the fundsinavalue-weightedindexincreases in

value and thenattracts a greatdealof capital The inflow ofinvestmenttothat fund

will haveamisleading effectonthe index Research has shown that indicescaneasily

suffer fromapopularity bias ofaparticular style, whichiscaused by inflows and

notthe actualreturn oninvestment.Evenwithout the popularitybias,adramatic

increase in onestylecanbiasanindex Theproblem with equally weighted indicesis

thattheyarenotrebalancedoften and effectively This lowers their investability

• Survivorship biasisabigproblem for hedge fund indices Indicesmaydrop funds

withpoortrack recordsorthatfail,causinganupward biasinreported values

Studies have shownthat the biascanbeashighas1.5-3%per year.Thedegreeof

survivorship biasvariesamong thehedge fund strategies Itislowerfor event-driven

strategies andhigher for hedged equity strategies

• Stale price biasvariesdependingonthe markets used by the hedge fund If the

fundoperatesinmarkets with infrequenttrading,the usualissuesof appraisalor

infrequent pricing and the resulting understatement of volatilitycan arise.The

evidencesuggeststhisisnot alarge problem

• Backfillorinclusion biasisasimilar problem butarisesfrom fillinginmissingpast

data It tendstobe directionallybiased,asonlymanagerswho benefit from the

missing data havean incentivetosupply the data.Itseemstobean issuewithsome

indices

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Study Session 13

LOS 25.f: Evaluate thereturnenhancement and/or risk diversificationeffects

ofaddinganalternativeinvestmenttoareferenceportfolio (forexample,a

portfolioinvested solelyincommonequity andbonds)

CFA®ProgramCurriculum, Volume5,page18

RealEstateRealestate is an assetclassaswellas analternativeinvestment.High risk-adjustedperformanceispossible because of the low liquidity, large lotsizes,immobility, hightransactionscosts,andlowinformationtransparencythatusuallymeansthesellerknows

morethan thebuyer

Realestatetypicallyreacts to macroeconomicchanges differentlythan stocksandbonds,

andeach investmenthasalarge idiosyncratic (unsystematic)riskcomponent.Because ofbothof thesecharacteristics,realestatehas provided diversification Using data for theperiod1990—2004,Figure 3comparesthereturnsof the indicated portfolios basedon

benchmarksfor the indicatedassetclasses

Figure3:PortfolioReturns From1990—2004

40/40/20 Stocks/Bonds/

Unsmoothed NCREIF

40/40/20 Stocks/Bonds/REITs

Sharperatio

9.33%

6.59%

Someconclusionsfrom Figure3andpastdata include:

• Addingeitherdirectrealestate orREITsto astock/bond portfolio significantlyincreases theportfolio Sharperatio

• The Sharperatiousing REITsisonly slightly better than the Sharperatiousingdirect realestate eventhough REITS hadahigherreturnfor the period becausedirect realestateproducesabetter diversificationeffect

PrivateEquityPrivate equity islessofadiversifier andmore along-termreturnenhancer.Privateequityinvestments (bothventurecapital and buyoutfunds)areusually illiquid, requirealong¬

term commitment,and haveahighlevelof risk with thepotentialforcompleteloss

In addition,thereisoftenaminoritydiscount associated with theinvestment.Because

of theseissues,investors requireahigh expectedinternalrateofreturn(IRR) Venturecapitalinvestmentshave lowertransparencythan buyoutfunds,whichcanactually add

tothepotential for largeprofits

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The differenceintransparencybetweenventurecapital funds and buyout fundsiscaused

by the differentnaturesof theinvestments.Venturecapital, for example,isprovidedto

new,non-public companiesinneed of capital for growth Bydefinition,themanagers

of firms receiving the funds have considerablymoreinformationonthetruevalueof

the firm than the investing public This addstothe risk facedbyventurecapital funds

but,atthesame time,increasesthe possiblereturn to venturecapitalists, who makeita

pointtolearnasmuch about the firmaspossible before investing Buyoutfunds,onthe

otherhand,usually provide capitalto managementsand otherstopurchase the equity of

publicly traded firms

Privateequityreturnstypicallymovewith stock marketreturns.Computed correlations

areoften positive andlow,butsomeattribute the low correlationtothe infrequently

updated(i.e., “stale”)prices of the private equity Eachinvestmenthasalarge

idiosyncratic riskcomponent,however,whichcanprovide moderate diversification

Because the primary benefit from private equityisreturnenhancement,Figure 4 gives

themostimportant information for comparison From thefigure,we seethatinthe

most recentyears,venturecapital funds and buyout funds hadalowerreturnthan both

small-cap and large-cap stocks (NASDAQ andS&P).Overthe longtermof20 years,

however,private equity had higherreturns.

Figure 4:ReturnstoPrivateEquity and Equity Markets

Commoditieschiefly offerdiversificationto aportfolio of stocks and bonds Correlations

of commodity indices with stocks and bonds have been low andevenslightlynegative

With the exception of the agricultural subgroups, commodity indices havea strong

positive correlation with inflation Thatisabenefittotheinvestorbecause they provide

ahedge againstinflation,while stocks and bondsarehurt by inflation

Thereturns oncommodities have generally been lower than stocks and bondsover

the period1990-2004,bothon anabsolute basis andarisk-adjusted basis Theenergy

subgroup of commodities has had the highestreturns,and withoutit,the broad GSCI

indexreturnwould have been much lower Figure5gives thestatisticsfor1990-2004

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Study Session 13

Figure5: IndexReturns From1990—2004m

1 GoldmanSachsCommodityIndex

Commoditieshave had higherreturnsin more recentyears Forthe sub-period of

2000-2004,theGSCI averagereturnof13.77%washigher than boththe —2.30%returnforstocksandthe 8.0%return onbonds.Thehigh volatilityof commodities, however, stillgave italower Sharperatiothan bonds(0.5forcommoditiesascomparedto 1.11for

bonds).

Weseehow commodities playauseful roleinthe portfolioinFigure6,whichcompares

a50/50 stock/bond portfolioto aportfolio withanallocationtocommodities The

return isslightlylower,buttheSharperatioishigher

Figure 6:PortfolioReturns From1990-2004

40/40/20 Stocks/Bonds/GSCI

years,asshown in Figure 7

Figure7: Portfolio Returns From2000-2004

40/40/20

Stocks/Bonds/GSCl

Measure (annualized)

overtheperiod1990-2004.The Hedge Fund Composite Index(HFCI) return,standard

Page 22

Trang 23

deviation,and Sharperatiowere13.46%,5.71%,and1.61,respectively Hedge funds

ranked betweenbondsand stocks inthemore recentperiod of2000—2004, wherethe

corresponding numberswere6.84%, 4.83%,and 0.86.For themore recentperiod,the

mean returnand Sharperatio ishigherthan the measures for stocks,but theyare both

lower than themeasuresfor bonds

Aswasthecaseformostofthe previousalternativeinvestments, a40/40/20 stock/bond/

HFCIportfolio hadahigherreturnand lower standard deviation than the 50/50 stock/

bond portfoliooverboth the1990-2004and2000-2004 periods

Hedge fundsvarywidely,however,sothe benefitsof investinginoneofany givenstyle

willdiffer.Figure8providesarepresentative list of the best andworstperforming funds

withtheir correlationswiththeS&P 500 andthe LehmanGovernment/Corporate Bond

Index.Thelasttwo rowsinFigure8comment oneach index’sreturnand how wellit

added diversificationoverthe period1990-2004

Figure8:Hedge Fund Strategy Index PerformanceFrom1990-2004

ManagedFutures

Managed futuresareusually considereda categoryof hedge funds andareusually

comparedtostocks andbonds,but their record has been similartothat of hedge funds

Overtheperiod1990—2004, thedollar-weighted indexofseparately managedaccounts

(CTA$)hada return,standarddeviation,and Sharperatioequalto 10.85%,9.96%,and

0.66,respectively, whichisabout thesame asstocks but withabetter Sharperatio.They

also hadahigherreturnthan bonds withalower Sharperatio

TheCTA$also ranked between bonds and stocksfrom2000-2004 The corresponding

numberswere 7.89%,8.66%, and0.60.Thereturn wascertainly higherthanthe

—2.30%returnfor stocksand slightlyless than the 8.0%returnforbonds; however,the

Sharperatioforbondswashigherat 1.11.

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Study Session 13

I Aportfolio consisting of 36/36/18/10 ofstocks/bonds/HFCI/CTA$accountshada

higherreturnandSharperatiothana40/40/20stocks/bonds/HFCI portfolio for boththelonger1990-2004and shorter2000-2004 periods

Note thatactively managedseparate accounts arethose where the managers seektotakeadvantageof mispricing opportunities Thereisevidencethat short-termmomentum

andotherstrategiescanproduceexcess returns.Managed futuresseem toprovideunique

returnsand diversification benefits Thisismade evidentfrom thenear-zerocorrelation

(-0.01)between theindexof separately managedaccountsanda50/50 stock/bondfund

DistressedSecuritiesDistressed securityreturnshave hadarelatively highaveragereturnbutalargenegativeskew,sothe comparisons using averagesand Sharperatios canbemisleading Theycanprovide highreturnsbecausemany investorscannothold distressed-debtsecurities,andfew analystscoverthe market Basedoncomparisons of theaveragereturnand Sharperatio,theHFRDistressed Securities Indexoutperformedboth stocks andbonds,both

on anabsolute andon arisk-adjustedbasis Thereturns areoftenevent-driven, sotheyareuncorrelated withthe overall stock market

Forthe Exam: Thediversificationbenefitsof alternativeinvestments arealsodiscussed

inStudySession8,AssetAllocation Bepreparedtodetermine whether alternativeinvestmentsareappropriate foraclient’s portfolio considering the client’s objectivesandconstraints.For theexam,thisisparticularlyrelevantforamorningcasewhereyouneed toallocate among severalassetclasses RememberfromStudySession8thattherearedrawbackstoadding alternativeinvestmentsto aportfolio (e.g.,amount

of capital required, lack of liquidity) but therearealso benefits (e.g.,diversification,

returnenhancement)

REAL ESTATEEQUITYINVESTING

LOS 25-g:Describeadvantagesanddisadvantagesof directequity investments

inrealestate.

CFA®ProgramCurriculum, Volume5,page20Direct equity realestateinvestinghas thefollowing advantages and disadvantages

Advantages:

• Manyexpensesare taxdeductible

• Abilityto use moreleverage thanmostotherinvestments

• Directcontrolof the properties

• Abilitytodiversify geographically

• Lowervolatility ofreturnsthan stocksevenafter correcting for smoothing

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• Highoperating andmaintenancecostsplus hands-onmanagementrequirements

• Special geographicalrisks,suchasneighborhood deterioration

• Politicalrisks,suchaschangingtaxcodes

VENTURE CAPITAL INVESTING

LOS25.h:Discussthe majorissuersandsuppliersofventurecapital,the

stagesthroughwhich privatecompaniespass(seed stagethroughexit),the

characteristicsourcesoffinancingateachstage,and the purpose of such

financing.

CFA®ProgramCurriculum,Volume5,page27

Inatypicalsequence,theventurecapitalist brings capitalto start acompany basedon

an attractivebusiness plan and/ortofund and growanexisting private company The

typicalexitplan involvesanIPO (initialpublic offering)tosell stocktothe public and

payoff the early privateinvestors.Thiscantakeyearsto execute.

Thereisanextensivevocabularytodescribeventurecapital Theissuers(companies

seeking capital) ofventurecapital includeformative-stagecompanies thatareeithernew

oryoung and expansion-stage companies that need fundstoexpand theirrevenuesor

prepare foranIPO

Theinvestors(suppliers) include:

• Venturecapitalistsarespecialists who identify pools of capital available for investing

inand find the promising private companiestoinvest in.Theymaypool investor’s

capitalintoventurecapital fundsor trusts.

• Corporate venturing referstolarge companies thatinvest inventurecapital

opportunitiesintheirown areaof business expertise

• Angelinvestorsareconsideredtobe knowledgeable, accredited individuals whoare

often the first outsiders(non-founders or relatives)whoinvest inthe company

Thestagesthroughwhich private companiespass areearlystage,expansionstage,

andexitstage.The earlystageincludes seedmoneyoftenputup by theentrepreneuror

other family memberstobeginprototypework,thenstart-upfundstobegin product

development and marketing, and first-stagefundingtobegin manufacturing and sales

Theexpansionstage canincludeveryyoungcompanies withanestablished product

lookingtoexpandsales,moreestablished companies seekingtofund growth,or even

companiessoontolaunchanIPO.Second-stagefinancingsupportsfurther expansion

of production andsales,while third-stage financingcansupportadditional major

expansion.Mezzanineorbridgefinancingisusedtoprepare foranIPOandmayinclude

both debt and equity capital

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Study Session 13

E Theexit stagecould involvean IPO,merger with another company,oracquisition by

anothercompany (whichmight bea venturecapital fund specializinginsuch activity)

LOS25.i:Compareventurecapitalfunds and buyout funds

CFA®ProgramCurriculum, Volume5,page39

Incontrast to venturecapitalfunds,buyout hinds usually have:

• Ahigherlevel ofleverage

• Earlier and steadier cash flows

• Less error inthemeasurementofreturns asmoreof thereturnisfrom cash flow

return.

• Lessfrequent losses

• Less upside potential

These differencesarethe naturalconsequenceof buyout funds purchasingentities inlaterstagesof developmentorestablished companies andcorporatespin-offs, where therisksarelower

CONVERTIBLE PREFERRED STOCK

LOS 25.j:Discusstheuseof convertiblepreferredstockindirectventure

capitalinvestment

CFA®ProgramCurriculum, Volume5,page 33Convertible preferred stockisagood vehicle for directventurecapitalinvestmentbecause preferred stockholdersmustbe paidaspecifiedamount(e.g.,twicetheir initialinvestment)beforecommonstockholderscan receivecashintheform of dividendsorother distributions.Anybuyout of the company thatisfavorabletoshareholders willleadtotheconversionof the preferred stock Typically,investors insubsequent rounds

of financingreceivepreferred stock withaclaim thatis seniortoanypreviously issuedpreferred stock Seniorityisincludedtoenticesubsequentinvestorsand makes thosepreferred sharesmorevaluable than those issued earlier

PRIVATEEQUITYINVESTING

LOS 25.k:Explainthetypicalstructureofaprivate equityfund,includingthecompensation tothe fund’s sponsor(general partner)andtypicaltimelines

CFA®ProgramCurriculum, Volume5,page 33Privateequity fundsusually take the formoflimited partnershipsorlimited liabilitycompanies(LLCs).These legalstructureslimit the losstoinvestorstothe initialinvestmentand avoidcorporatedoubletaxation.Forlimited partnerships, thesponsor

iscalled the generalpartner,forLLCs,thesponsor iscalled themanagingdirector Thesponsorconstructsand manages the fund and selects and advises theinvestments

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Thetimelinestartswith the sponsor gettingcommitmentsfrominvestorsatthe

beginning of the fund and then giving“capital calls”overthe first fiveyears(typically)

Thisisreferredto asthecommitmentperiod The expected life of these fundsisseven to

tenyears,and thereisoftenan optiontoextend the lifeuptofivemoreyears

Thesponsor can receivecompensationinseveralways.First,thesponsorhas capital

invested thatearnsa return.Thisisusually required,asithelps keep thesponsor’s

interests inline with thoseof the limitedpartners.Asamanager, thesponsor typically

gets a managementfeeandincentivefee.

Themanagementfeeisusually 1.5%to2.5%andisbaseduponthe committedfunds,

notjust funds already invested Thepercentmaydeclineovertimebaseduponthe

assumption that themanager’swork declinesover time

Theincentive fee isalso called the carriedinterest.Itisthe shareof the profits, usually

around20%,thatispaidtothe manager after the fund has returned the outside

investors’ capital—often afteraminimumrequiredreturn orhurdleratehas been paid

onthe cashfrom the outsideinvestors.Insome cases,themanagercanreceiveearly

distributions basedonexpectations, butaclaw-back provisionmaybeinplacethat

requires the managertogive backmoneyif the expected profitsarenotrealized

PRIVATEEQUITYINVESTMENT STRATEGY

LOS25.1:Discuss issues thatmustbe addressedinformulatingaprivate equity

investmentstrategy

CFA®ProgramCurriculum,Volume5,page 41Anystrategyfor private equityinvestmentmustaddress thefollowingissues:

• Lowliquidity:the portfolio allocationtothis class should typically be 5%orless

withaplantokeep themoneyinvested forsevento tenyears

• Diversificationthroughanumberofpositions: becausecommitments areusuallylarge,

onlyinvestorswith portfoliosover$100 millioncan invest inthenecessaryfiveto

teninvestmentsneededfor diversification.Diversified,commingled fundsexistfor

smallerinvestors,but these funds have additional fees

• Diversificationstrategy:knowing the uniqueaspectsofaproposed private equity

investmentasthey relatetothe overall portfolio

• Plansformeetingcapital calls: committed fundsarecalledasneeded,and theinvestor

needstobe preparedto meetthe calls

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Study Session 13

COMMODITYINVESTINGm

LOS 25.m:Compare indirect and direct commodityinvestment

The increase in thenumberof investableindices incommoditiesand theirassociatedfuturesisindicativeof theadvantagesof investingviaderivatives Theseindicesalsomake investing incommodities availabletosmaller investors

THE TERM STRUCTURE OFFUTURES PRICES

LOS 25-n:Explain the threecomponentsofreturnforacommodity futures

contractand theeffect thatanupward-ordownward-slopingterm structureoffutures prices will haveon roll yield

CFA®ProgramCurriculum, Volume5,page49Thecomponentsof thereturn to acommodity futurescontract arethespot return ,thecollateralreturn,andtherollreturn.Thesecomponents areusually consideredtobeadditive,so one component canbe calculated given the value of the others:

totalreturn=spot return +collateralreturn +rollreturn

Spotreturn orpricereturnof the underlying commodity.Forexample, ifcornpricesrise 2%for the period, thespot returnfor the futurescontractis 2%.Spotreturn canbepositiveornegative

Collateralreturnisthe periodic risk-freereturn.Theimplicit assumptionisthatcashequivalents equaltothefullprice of thecontractpositionareheld.Forexample, ifcorn

contracts areheldonemonthandtheperiodicrisk-freerate is 0.3%,thecollateralreturn

is0.3%.Collateralreturnwillbe positive

Rollyieldor returnisthe changeinthefuturescontractpriceforthetimeperiodminusthe changeinthespotprice of the commodity for theperiod Itcanbe positive

ornegative andisaffected by the shape ofthefuturesterm structure.Backwardation is

adownward-slopingterm structureof futures prices(i.e.,each successivefuturesprice

is lower).Suchacondition predictsapositive rollreturn, asthefuturesprice increases

toconvergewith thespotpriceatthe expiration of thecontract.If theterm structureisupward-sloping, calledcontango,the rollreturnwould be negative

Page 28

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Example: Calculatingtherollreturn to acommodity futurescontract

The changeinpriceonafuturescontractis $6,thespot returnis $3,and the

collateralreturnis$1.Calculate the rollreturn.

Answer:

rollreturn=changeinfutures price-spot return=$6 - $3=$3

The collateralreturnisnot partof the changeinthefutures price andisnotincluded

inthe calculation for the rollreturn.

COMMODITIESAND INFLATION

LOS 25.o:Describe theprincipalrolessuggestedfor commoditiesina

portfolioandexplainwhysomecommodity classesmayprovideabetterhedge

against inflation than others

CFA®ProgramCurriculum,Volume5,page 54Commodities generally provideadiversification benefittotraditional portfolios Some

commodities also provide specific diversification and protection against unexpected

increases ininflation.Twofactors affect whetheracommodityisagoodhedgeagainst

unexpected inflation: storability and demand relativetoeconomicactivity

Whetheracommodityisstorableisthe primary determinantin itsvalueprovidinga

hedge against unexpected inflation.Forexample, the values of storable commodities

suchasprecious metals (e.g., gold,silver),industrial metals (e.g.,zinc,aluminum,

copper), andenergy(e.g., crudeoil,heatingoil,natural gas)arepositively relatedto

unexpected changesininflation Thatis,they tendto increase (decrease)invalue with

unexpectedincreases (decreases) ininflation They have provided good diversification

againstunexpected inflation

Non-storable commodities like agricultural commodities (e.g.,livestock, wheat,corn)

have shown values thatarenegatively (positively) affected by unexpectedincreases

(decreases) ininflation They havenotprovided diversification against unexpected

inflation

Anotherfactortoconsider withrespect toinflationhedgingcapabilityiswhether

the commodity’s demandislinkedtoeconomic activity.Those that enjoyamoreor

lessconstantdemand regardless of the level ofeconomic activity,for example,seem

toprovide little hedge against unexpected changesininflation Again, agricultural

commodities tendtofallintothisgroup.Those commodities thataremostaffected by

thelevelofeconomicactivity(e.g., energy, preciousmetals)tendtobe better hedges

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Study Session 13

LOS 25.p:Identifyandexplainthe style classification ofahedgefund,givena

descriptionofits investmentstrategy

CFA®ProgramCurriculum, Volume5,page 58

Professor’sNote: Thefollowing material relatestoLOS 25.d and 25.p

Hedge fundsareclassifiedin various waysby differentsources.Because hedge fundsare

a“style-based”assetclass,strategiescandetermine the subgroups Within the strategies,therecanbeeven moreprecise subgroups suchaslong/short and long-only strategies

The followingisalistofnineof themorefamiliar hedge fund strategies

1. Convertiblearbitrageseekstoexploit mispricingsoranomaliesinthe price ofconvertiblesecuritiessuchasconvertiblebonds,convertible preferredstock, or

warrants.Both long and short positionsaretakentohedge the risks.A commonexampleistobuy undervalued convertible bonds and short the stock Theinvestorownsthe convertible which includesa“call option”onthe stock and shorts the stockwhich should leave the position hedged against changesinthe stock price.Interest

isearned from the bondcouponsand from investing the proceeds of the short-sale

Thestrategywould benefit if stockvolatilityincreasesand the convertiblerises invalue.(Thevalueof the embedded call optionintheconvertible shouldrisewithincreasing volatility.) If the yieldcurve isupward sloping, making the yieldonthebond higher than shorttermborrowingrates,thestrategymight also be leveragedto

enhancereturns.

2 Distressedsecuritiesarefundamentally differentinvestmentsthan conventional debtand equityinvestments.Manyinvestorsarenotallowedtoordonot want todealwith the legal complications for thesesecurities.The resultingsecuritiesmaybeundervalued andoffer superiorreturns.Distressedsecuritiesaregenerally illiquid,makingitdifficultorimpossibletoshort thesecurities.These fundsaregenerallylong(nothedged) portfolios

3 Emerging marketsgenerally only permit long positions, and often therearenoderivativestohedge theinvestments

4 Equity market neutral typically combineslongand short positionsinunder¬

valued andover-valuedsecurities(pairs trading)toeliminate systematic risk whilecapitalizingonmispricing

5 Hedged equitystrategiestake long and short positionsinunder- and over-valuedsecuritiestoexploit mispricings Unlike market neutralfunds,they donotseek

toremovesystematic risk.They might benetlong,short, orhedged basedonthemanager’sviewof the markets

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6 Fixed-income arbitrage involves taking long and short positionsinfixed-income

instrumentsbaseduponexpected changesinthe yieldcurveand/or credit spreads

7- Globalmacrostrategies take positionsinmajor financial and non-financial markets

throughvariousmeans(e.g., derivatives andcurrencies).The distinguishing feature

isthatthey tendtofocuson anentiregrouporareaofinvestmentinsteadof

individualsecuritiesorclassesofsecurities

8 Mergerarbitrageordeal arbitrage focusesonreturnsfrom mergers, spin-offs,

takeovers,andsoon.Forexample, if CompanyX announces itwill acquire

CompanyY,the manager might buy sharesinYand shortX

9 Fundoffunds(FOF)describesahedge fund thatinvests inmanyhedge funds The

ideaisto getdiversification among hedge fund managersorstyles, but thereisafee

paidtothe manager of the fund offunds,aswellas tothe managers of the fundsin

the fundof funds

Anotherclassification scheme divides hedge funds strategiesintofivegeneralsegments:

1)relativevalue,2) event-driven, 3)hedged equity,4)globalassetallocators,and5)short

selling

1 Relative value strategiesattempt toexploit price discrepancies Thiscategory

combines the equity marketneutral,the convertible arbitrage, and fixed-income

arbitrage strategies mentioned previously As thenameimplies, thisstrategy

compares the relative values ofassetsandattempts tocapitalize, throughvarious

long and short strategies,onthe relative mispricing

2 Event-driven strategiesinvestwithashort-termfocusonaneventlikeamerger

(merger arbitrage)orthe turnaroundofadistressed company(distressed securities)

3 Equity hedge entails taking long and short equity positions with varying overallnet

longorshort positions andcaninclude leverage

4 Globalassetallocators take long and short positionsinavarietyof both financial and

non-financialassets.

5 Short selling takes short-only positionsinthe expectation ofadeclineinvalue

Asaskill-basedinvestment class,the risk andreturnofahedge fund depends heavily

uponthe skillof the manager Wecanmakeadistinction concerningrisk, however,

inthatstyles thataremainly long-only (e.g., distressedsecurities)tendtooffer less

potential for diversification than long/short styles, and liquiditycanvaryfrom fundto

fundor evenwithin subgroups

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Study Session 13

LOS 25.q:Discussthetypicalstructureofahedgefund,includingthefee

structure,andexplainthe rationaleforhigh-watermark provisions

CFA®ProgramCurriculum, Volume5,page 60Themostcommoncompensationstructureofahedge fundconsistsofanassets-under-

management(AUM)fee of about1%to2%andan incentivefeeof20%of profits Thedefinitionof profit should be spelledoutinthetermsof theinvestment.It could be thedollarreturnoverthe initialinvestment,for example,orthe dollarreturnabove theinitialinvestmentincreasedbysomehurdlerate.

Highwatermarks(HWMs)aretypically employedtoavoidincentivefee double¬

dipping.Forexample,assumeafundisvalued and opened for subscriptionon

aquarterly basis Eachquarter,theincrease invalueoverthe previousquarterisdetermined andinvestors pay incentiveandmanagementfees accordingly Thisis fine,

aslongasthe fund’s valueishigherateachsuccessivevaluation If the valueof the fund

islower than the previousquarter,however,the managerreceivesonly themanagement

fee,and the previous high value of the fund (i.e.,the last fund valueatwhichincentivefeeswerepaid)isestablishedas aHWM Investorsarethen requiredtopayincentivefees only if and when the value of the fundrisesabove theHWM Notethat HWMsare

investor-and subscription-datespecific For thosewhosubscribe whilethefund value

isbelow the previously establishedHWM,thatHWM isnotrelevant They will pay

managementfees eachquarter, aswellasincentive fees,forincreases invalue above thevalueattheir subscription date

Alock-up periodisa commonprovisioninhedge funds Lock-up periods limitwithdrawals by requiringaminimum investmentperiod (e.g.,onetothree years) anddesignatingexitwindows The rationaleisto preventsudden withdrawalsthat couldforce the managertohavetounwind positions

Incentivefeesarepaidtoencourage the managertoearnever-higher profits Thereis some controversyconcerningincentivefees because themanagershould have goals otherthan simply earningagrossreturn.Forexample, themanager maybe providing limiteddownside risk and diversification.An incentivefee baseduponreturnsdoesnotrewardthisservice

Managers withgood track records often demand higherincentivefees Theconcernforinvestors iswhether the manager withagood historical recordcan continuetoperformwell enoughtotrulyearnthe higher fees

Page 32

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FUNDOFFUNDS

LOS 25.r:Describe the purpose and characteristics of fund-of-fundshedge

funds

CFA®ProgramCurriculum,Volume5,page 60

Afundoffunds(FOF)isahedge fund thatconsistsofseveral,usually10to 30,hedge

funds The pointistoachievediversification,but theextralayer ofmanagementmeans

an extralayer of fees.Often,anFOFoffersmoreliquidity for theinvestor,but thecost

iscash drag caused by themanagerkeepingextracashto meetpotential withdrawals by

otherinvestors.Despite thedrawbacks,FOFaregood entry-levelinvestments

AnFOFmaybeabetter indicator ofaggregatehedgefundperformance than the typical

hedge fund index becauseitsuffers from less survivorship and backfill bias IfanFOF

includesahedge fund thatdissolves, itincludes theeffect of that failurein itsreturn,

whileanindexmaysimply drop the failed fund along withitshistoricalperformance

AnFOFcan,however,suffer from style drift Thiscanproduce problems because the

investor maynotknow what sheisgetting Overtime,individual hedge fundmanagers

maytilt their respective portfoliosindifferent directions.Also, it isnotuncommonfor

twoFOFthat claimtobeof thesamestyletohavereturnswithaverylow correlation

FOFreturnshave beenmorehighly correlated with equity markets than those of

individual hedge funds This characteristic has important implications for theiruse as

diversifiersinanequityportfolio

HEDGE FUND PERFORMANCE EVALUATION

LOS 25.s:Discussconcernsinvolvedinhedgefundperformanceevaluation

CFA®ProgramCurriculum,Volume5,page 64The hedge fund industryviewshedge fund performance appraisalas amajorconcern

withmanyspecialissuesandconventionstoaddress One specialissue isthatsomeclaim

that hedge fundsareabsolute-returnvehicles,whichmeansthatnodirect benchmark

exists Instead,the fundtargets someabsolutereturnperperiod Thattarget returnis

notreallyabenchmark becauseit isnotinvestable.Thequestion(andproblem)ishow

todetermine alpha The problemisespecially perplexing given thatmostperformance

evaluation techniquesarebasedonlong-only positions and hedge fundsusevarious

combinationsof long and short positions and leverage Tocreatecomparable portfolios,

analystsmight1) use asingle-ormulti-factor modelor 2) createtrackingportfoliosthat

have comparablereturnand risk characteristics.Ineithercase,the resulting customized

benchmarkisusedfor subsequent evaluation

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Study Session 13

I Conventionstoconsiderinhedge fundperformance evaluation aretheimpactof

performance fees and lock-up periods, theage of funds,and thesizeof funds Empiricalstudieshave found that:

• Funds with longer lock-up periods tendtoproduce higherreturnsthan those withshorter lock-up periods

• Younger funds tendtooutperform older funds

• Large funds underperformsmallfunds

Returns.Byconvention,hedge fundsreportmonthlyreturnsby comparing the endingvalueof thefundtothebeginning value[i.e.,(Vj/VQ)-1],Thesesimply-calculatedmonthlyreturns arethencompoundedtoarriveatannualreturns.Notethatreturns are

often biased byentryintoandexitfrom thefund,whichareallowedon aquarterlyor

lessfrequentbasis,andbythefrequency of the manager’s trading(i.e.,cash flows)

Professor’sNote: You willseeintheGIPS®materialinStudySession 18that theway cashflowsarehandledaffectsthe resultingreturncalculations

To smoothoutvariabilityinhedge fundreturns,investorsoftencompute arolling

return,suchas a12-month movingaverage A12-month movingaverage istheaveragemonthlyreturn overthemost recent12months,includingthecurrentmonth Thenext

moving averagereturn iscalculated by addingthenextmonthand droppingthemost

distantmonth In this fashion, the averagereturn isalways calculated usingreturnsfor

12months

Leverage Theconventionfor dealing with leverageisto treat an asset asifitwerefullypaid for(i.e.,effectively “look through” the leverage) When derivativesareincluded,the

sameprincipleofdeleveragingisapplied

Risk.Using standard deviationto measurethe riskofahedge fundcanproducemisleading results.Forexample, hedge fundreturns areusuallyskewed withsignificantleptokurtosis(fattails),sostandard deviation failsto measurethetrueriskofthedistribution(i.e.,standard deviation doesnotaccuratelymeasurethe probability of

returnsin thetails)

Downside deviation Downside deviationmeasuresonly the dispersion ofreturnsbelow

somespecified thresholdreturn.Themost commonformula for downsidedeviationis:

2lmin(return,.—threshold,0)

= 1

downside deviation

n—1

Thethresholdreturnin theformulaisusuallyeitherzero orthe risk-freerateofreturn.

Ifthethresholdis a recentaveragereturn,thenwecall thedownside deviationthesemivariance.Thepointof thesemeasuresistofocusonthe negativereturnsandnot

penalizeafundfor high positivereturns,whichincreasesmeasured standard deviation

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Professor’sNote:Itisfairly easytovisualize howearning afew veryhighreturns

in conjunction withaveragereturnscould producealarge standarddeviation,

evenwhen the manager producednonegativereturns.In thiscase, weshouldproperly conclude that the manager performed wellonarisk-adjustedbasis,

butusingstandard deviationtomeasurevariability(i.e., risk)could leadus toconclude that the manager took unnecessary risk

TheSharpeRatio

Annual hedge fund Sharperatiosarecalculated using annualizedmeasures, asdiscussed

earlier:

annualizedreturn—annualized risk-freerate

SharpeHF=

annualized standard deviation

In additiontoconcernsassociatedwith thewayreturnsare calculated,theSharperatio

has the following limitations withrespect tohedge fund evaluation:

• Timedependency:The annual Sharperatio istypically estimated using shortertime

periods.Forexample,toestimatethe annual Sharperatioforahedge fund using

quarterlyreturns,the analyst multiplies the quarterlyreturnby 4 and multiplies the

quarterly standard deviation by thesquarerootof4.Thus,the annualized Sharpe

ratio isbiased upward by thesquarerootof4

• Assumesnormality:Measures that incorporate standard deviationareinappropriate

for skewedreturndistributions

• Assumesliquidity:Becauseof infrequent, missing,orassumedreturnobservations,

illiquid holdings have upward-biased Sharperatios (i.e.,downward-biased standard

deviations)

• Assumesuncorrelatedreturns:Returns correlatedacross timewill artificially lower

the standard deviation.Forexample, ifreturnsaretrending foraperiod oftime,

the measured standard deviation will be lower than whatmayoccur inthefuture

Serially-correlatedreturnsalso result when theassetisilliquid andcurrentpricesare

notavailable (e.g.,privateequityinvestments).

• Stand-alonemeasure:Doesnotautomatically consider diversification effects

Inadditiontothese statistical shortcomings, the Sharperatiohas been showntohave

littlepowerfor predictingwinners(i.e.,ituseshistoricaldata).Also,research has found

evidence that managerscanmanipulate their reportedreturns toartificially inflate their

Sharperatio

MANAGED FUTURES

LOS 25.t:Describetradingstrategies ofmanagedfutures programs and the

roleofmanagedfuturesinaportfolio.

CFA®ProgramCurriculum,Volume5,page90Managed futures programsaretypicallyrunby Commodity Pool Operators(CPOs)

CPOscanthemselves be commodity trading advisors(CTAs)orwill hire CTAsto

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Study Session 13

E actually manage allor partof the pool In the UnitedStates,bothmustbe registered

with theU.S.Commodity Futures TradingCommissionand the National FuturesAssociation

Managed futures(CTAs) aretypically classified by style, the marketsinwhich theyspecialize,orbystrategy.Because they often seek performanceinmajormarkets,managed futuresare sometimesthought ofas asubsetof globalmacrohedge funds thatspecializeintrading derivatives

Professor’sNote:Some CTAsprefernot towork within thestructureofa private

orpublic pool(CPO)

CTA strategiescanbe describedassystematic ordiscretionary CTAs that specializeinsystematictrading strategies typically applysetsof rulestotrade accordingtoshort-,intermediate-,and/or long-term trends Theymayalso tradecounter totrendsina

contrarian(against thetrend)strategy.

Adiscretionary tradingstrategyismuchasitsounds Thestrategyisbasedonthediscretionof the CTA (commodity tradingadvisor), inthesame waythatany activemanager seeks value

Managed futurescanalso be classified accordingtothe marketsinwhichthey trade

They applysystematic ordiscretionary trading strategiesinfinancialmarkets, currencymarkets,ordiversified markets

\t\financialmarkets,they tradeinfinancial(i.e., interest rate)andcurrency futures,options, and forwardcontracts.Those that specializein currencymarkets trade exclusively

in currencyderivatives.Afundthat tradesindiversifiedmarkets tradesinall the financialderivatives markets describedaswellascommodity derivatives

Roleinthe PortfolioThe primary benefittomanaged futuresisthe significant diversification potential(i.e.,improved Sharperatios) Forexample,someresearch hasevenshownthat managedfutures have exhibited positive correlationtoequities and bonds duringupmarketsand negative correlations during fallingmarkets,although theperformanceseems toberelatedtospecific strategies andtimeperiods In particular, private fundsseemtoaddvalue whereas publicly traded funds have performed poorly, both stand-alone andinportfolios

InselectingaCTAtoincludeinthe portfolio, the manager should consider risk

Forexample,eventhough CTAs often exhibit negative correlations with equities,correlationsamongCTAsthemselvescanrange anywhere fromsignificantlypositive

(i.e.,closeto1.0)toonly modestly positive.In addition,the beta that relates theperformance ofanindividual CTAto afundof CTAscanbeagood indicator of futurerisk-adjustedperformance.Justasequity beta relates the volatility(risk)ofanindividualequity securityorportfoliotothe overall equitymarket,the CTA betameasuresthe risk

of the individual CTA relativeto afundofCTAs

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DISTRESSEDSECURITIESINVESTING

LOS 25.u:Describe strategies and risks associated with investingindistressed

securities

CFA®ProgramCurriculum,Volume5,page95The majortypesof distressedsecuritiesinvesting strategiesarelong-only value

investing, distressed debtarbitrage, and private equity

Long-only value investing basicallytriestofind opportunities where theprospectswill

improveand,ofcourse,triestofind them before otherinvestorsdo High-yieldinvesting

isbuying publiclytraded,below-investment grade debt Orphan equitiesinvesting isthe

purchase of the equities of firms emerging from reorganization Thereasonthesepresent

amarket opportunityisthatsome investorscannotparticipateinthis market andmany

donotwishtodo thenecessarydue diligence

Professor’sNote: Anissueofdebt that hasfallen frominvestmentgradetoinvestmentgradeisreferredtoasa “fallenangel.”

below-Distressed debt arbitrageisthe purchasing ofacompany’s distressed debt while short

sellingthe company’s equity Theinvestmentcan earn a returnintwoways:1)if the

firm’s conditiondeclines,the debt and equity will both fallin value;the equity should

declinemorein value,though, because debt hasseniority;and2)if thecompany’s

prospectsimprove, because of the priority ofinterestoverdividends,thereturns to

bondholders should begreaterthan that of equityholders,includingdividends paidon

the short position The possibility ofreturnsfrom thetwo eventsprovidesagoodmarket

opportunity

Private equity is an“active” approach where theinvestoracquires positionsinthe

distressed company, and theinvestmentgivessome measureof control Theinvestorcan

then influence andassistthecompanyaswellasacquiremoreownershipintheprocess

ofanyreorganization.Byprovidingservicesand obtainingastrategic position, the

investorscreatetheirownopportunities Vulturefunds,which specializeinpurchasing

undervalued distressedsecurities,engageinthistypeofstrategy.

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Study Session 13

LOS 25.v:Explaineventrisk,marketliquidityrisk,marketrisk,and“J-factor

risk”inrelationtoinvestingindistressedsecurities

CFA®ProgramCurriculum,Volume5,page101Distressedsecurities canhaveeventrisk,marketliquidityrisk,marketrisk,J-factorrisk,and othertypesof risk

• Event riskreferstothefact that thereturn on aparticularinvestmentwithin thisclass typically dependsonaneventfor the particular company.Becausetheseevents

areusually unrelatedtotheeconomy,theycanprovide diversification benefits

• Market liquidity risk referstolow liquidity and the fact that therecanbecyclicalsupply and demand for theseinvestments

• Market riskfrommacroeconomicchangesisusually lessimportantthan thefirsttwo

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KEY CONCEPTS

LOS 25.a

Commonfeatures of alternativeinvestmentsinclude:

• Lowliquidity

• Good diversification potential

• High due diligencecosts.

• Difficulttovalue

• Limitedaccess toinformation

Alternativeinvestmentscanprovide:

• Exposureto assetclasses that stocks and bondscannotprovide

• Exposuretospecialinvestmentstrategies(e.g., hedge andventurecapitalfunds)

• Special strategies and uniqueassetclasses (e.g., funds thatinvest inprivate equity

and distressedsecurities)

LOS 25.b

• Assessthe market opportunity offered Are there exploitable inefficienciesinthe

marketfor thetypeofinvestments inwhich themanagerspecializes?

• Assesstheinvestment process Doesthemanagerseem tohaveacompetitive edge

overothersinthat market?

• Assessthe organization of the manager anditsoperations.Is itstable and wellrun?

What has been thestaffturnover?

• Assessthe people by meeting with them and assessing their character

• Assessthetermsandstructure (amountandtimeperiod) of theinvestment

• Assesstheserviceproviders(i.e.,lawyers,brokers,ancillarystaff,etc.)by

investigating the outside firms thatsupportthemanager’sbusiness

• Reviewdocuments suchastheprospectus orprivate-placement memorandum and

the audits

LOS 25.c

• Taxes Taxissuescanbe uniquetothe individual because the characteristics of

private-wealth clients andtheir investments can varygreatly.Forindividuals,there

canbe partnerships,trusts,and othersituationsthat maketaxissuescomplex

• Suitability.Timehorizons and wealthof individualscanvarya greatdeal With

individuals,thereisalso the emotionalaspect,likepreferencesfor,oraversionto,

certaintypesofassets.

• Communication Communicationwith the client helps determine suitability of

recommendations and the overallmanagementprocess

• Decisionrisk.Decisionriskisthe riskof irrationally changinga strategy.For

example, the advisermustbe preparedtodeal withaclient whowants to get outofa

positionthat has just declinedinvalue

• Concentrated positions Wealthy individuals’ portfolios frequentlycontainlarge

positionsinclosely held companies Such ownership should be considered with the

overall allocationtoalternativeinvestments,like private equity

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• Companies thatdevelop andmanagerealestate.

• Realestateinvestmenttrusts(REITs)

• Commingled realestatefunds(CREFs).

• Separately managedaccounts.

• Infrastructure funds

Privateequitysubgroups includestart-upcompanies, middle-market private companies,and privateinvestment inpublicentities.A directinvestment inprivate equityiswhentheinvestorpurchasesaclaimdirectly from the firm (e.g., preferred shares ofstock)

Indirectinvestment isusually donethroughprivate equityfunds,which includeventurecapital(VC)andbuyout funds

Commodityinvestmentscanalso be groupedintodirect and indirect subgroups.Directinvestment iseither through the purchase of the physical commodityorthe purchase ofderivatives (e.g.,futures) onthoseassets.Indirectinvestment incommoditiesisusuallydone throughinvestment incompanies whoseprincipal businessisassociated witha

commodity (e.g., investingin ametalviaownership of sharesinaminingcompany)

Many commodities havealowcorrelation with stocks and bonds andapositivecorrelation with inflation

Managed futures funds sharemanycharacteristics withhedgefunds The primary featurethat distinguishes managed futures from hedge fundsisthe differenceintheassetstheyhold Managed futures funds tendtotradeonlyinderivativesmarkets,while hedgefunds tendtotradeinspotmarkets andusefutures for hedging.Also,managed futuresfunds generally take positions basedonindices,while hedge funds tendtofocusmore

onindividualassetprice anomalies In otherwords,hedge funds tendtohavemoreofa

micro focus,while managed futures tendtohaveamacrofocus

Buyout fundsarethe largestsegmentof the private equity market Middle-marketbuyout fundsconcentrateondivisions spun off from larger, publicly traded corporationsand private companiesthat,duetotheirrelatively smallsize, cannotefficiently obtaincapital Mega-cap buyout fundsconcentrate ontaking publicly traded firms private Ineithercase,thetarget representsan investmentopportunitythroughthe identification

of under-valuedassets,the abilityto restructurethe debtof thefirm,and/or improved(i.e., more efficient)managementand operations

Infrastructure funds specializeinpurchasing public infrastructureassets(e.g.,airports,tollroads)fromcities, states,and municipalities Distressedsecuritiesare securities

of companies thatareinor nearbankruptcy.Aswith managedfutures,analystsoften consider distressedsecuritiestobepartof the hedge fund class of alternativeinvestments.Itmayalso bepartof the private equity class

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