CAIA notes CAIA level II book 2

T O P I C 8 Asset Allocation M a i n P o i n t s Comparing and contrasting buy-and-hold, constant mix, and constant-proportion portfolio insurance strategies Applying a wealth allocat

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CAIA ® Notes

Book 2 (Topics 7-11) September 2009 Exam

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or identified corrections will be communicated to all purchasers No statement in this book is to be construed as a recommendation to buy or sell securities Product

ERIK BENRUD, CAIA, CFA, FRM

Curriculum Director

Erik Benrud is an associate clinical professor of finance at Drexel University’s LeBow College of Business, Philadelphia His research interests are hedge funds, swaps and options, and competi- tion in financial services Dr Benrud has earned the CAIA, CFA and FRM designations He has extensive experience in teaching and writing exam preparatory material He has authored sever-

al papers in derivatives, financial services, and financial forecasting Dr Benrud received his Ph.D from the University of Virginia.

VIKAS AGARWAL

Topic Author

Vikas Agarwal, who was Curriculum Director of IIExamPrep for two exam cycles in 2008-09, is

an assistant professor of finance at Georgia State University in Atlanta He is widely published on hedge fund strategy and performance, and has been teaching courses on asset pricing and the financial system at Georgia State University since 2001 He has a Ph.D in finance from the London Business School

DONALD R CHAMBERS, CAIA

Topic Author

Don Chambers, who was Curriculum Director of IIExamPrep until March 2008, is the Walter E Hanson/KPMG Peat Marwick Professor of Business and Finance at Lafayette College in Easton, Penn He is widely published on investments, corporate finance, risk management, and alterna- tive investments Dr Chambers was one of the first candidates to earn the CAIA® designation, and has played a leading role in designing learning materials for those taking the CAIA® exami- nation.

HENRY A DAVIS

Topic Author

Henry (Hal) Davis, an independent consultant, is editor ofThe Journal of Structured Finance

and The Journal of Investment Compliance He has written and co-authored 15 books and

numerous articles in the areas of corporate finance and the financial markets.

URBI GARAY

Topic Author

Urbi Garay is a professor of finance at the IESA Business School in Caracas, Venezuela, and is rently a visiting professor and researcher at the Isenberg School of Management and the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachus- etts, Amherst He teaches both MBA and undergraduate courses in investments, derivatives prod- ucts, corporate finance and international finance.

T ABLE OF C ONTENTS

PART 5: CURRENT AND INTEGRATED TOPICS

Topic 7: Structured Products, New Products and New Strategies 1

Topic 8: Asset Allocation 19

Topic 9: Current Topics 47

Topic 10: Portfolio and Risk Management 73

Topic 11: Research Issues in Alternative Investments 81

GLOSSARY 105

INDEX 117

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Navigating the CAIA ® Notes

CAIA® Notes are comprehensive study materials organized to prepare you for the

forthcoming CAIA® Exam The CAIA® Notes are most effective when used in

con-junction with the CAIA® Study Guide and original reading materials, and tional Investor’s CAIA® Prep software

Institu-CAIA® Notes Level 2, Book 2 (Topics 7-12) is organized around the CAIA® Study

Guide’s “Learning Objectives”: it gives you summaries and explanations of what our experienced authors believe are the most important issues in the curriculum That is, it provides you with the material that is most likely needed to correctly re-spond to the CAIA® exam questions

CAIA® Notes begins by listing the CAIA Association® Course Outline by Topic and

Learning Objective You can quickly reference a particular Learning Objective by turning to the page number against each Learning Objective

Each Topic starts by listing the Main Points from the CAIA® Study Guide Within that Topic, it then goes through the explanations for each Learning Objective and its sub-parts The Learning Objectives are summarized using various explanations, examples, and calculations, where appropriate Keywords are highlighted within each Topic to remind you of these important terms as you read Each Topic also lists the original source references

The Glossary aims to provide useful information directly related to the Keywords Each entry in the Glossary refers back to its relevant Topic The Index at the end also highlights the Keywords In the Index, the page numbers in bold are the pages

on which a Keyword is found in its respective Topic

Various icons are placed throughout the books to point out calculations,

referenc-es, and note-worthy items We have also boxed out important equations for quick reference (you can also find a separate Formula Sheet at www.iiexamprep.com) All

of these features should assist you with your navigation through the various Topics

as you study

For your convenience, we have produced both a digital and paper version of CAIA®

Notes This allows you to download CAIA® Notes onto your laptop, or bring the

book with you in your briefcase, so that you can study anytime, anywhere

This CAIA Association® listing is by Topic and Learning Objective Each Learning Objective within a Topic has a page number

(in brackets) for this CAIA® Notes book

PART 5: CURRENT AND INTEGRATED TOPICS

TOPIC 7: Structured Products, New Products and New Strategies

7.5 Describe the conceptual characteristics of infrastructure sectors (3)

a RREEF Hypothetical Infrastructure Index

b UBS Global Infrastructure & Utilities Index

c Moody’s Economy.com Infrastructure Index

7.10 Explain the economic implications of climate change in terms of its impacts on existing assets, future economic

activity, increased regulation, and consumer behavior (7)

a markets for catastrophe and weather risks

c climate-related investments

7.12 Explain the economics rationale for using financial instruments to transfer risk (9)

7.13 Discuss the criteria that need to be fulfilled by instruments employed for risk transfer (9)

7.14 Describe existing instruments that can be used to transfer risk and identify potential investors and sponsors of

these instruments (10)

7.15 Describe both exchange traded as well as over-the-counter weather derivatives (11)

7.16 Describe emissions trading, its project based mechanism, and its potential market participants (11)

7.17 Compare the factor-based approach to hedge fund replication with the payoff distribution approach to hedge

fund replication, in terms of their: (12)

7.18 Discuss the term convergence as it is applied to the alternative investments industry (14)

7.19 Compare and contrast the historical objectives of private equity funds with that of hedge funds (14)

7.20 Contrast recent hedge fund participation in traditional private equity activities with recent private equity

participation in traditional hedge funds activities (15)

7.21 Explain why the distressed investment space provides an excellent example of recent convergence of hedge fund

and private equity strategies (16)

7.22 Describe the emergence of the hybrid hedge fund/private equity fund (16)

7.23 Discuss the factors that contributed to the convergence of private equity and hedge fund strategies referencing

recent trends in the area (17)

7.24 Discuss the concerns and risks related to the trend toward convergence of hedge fund and private equity fund

strategies (18)

TOPIC 8: Asset Allocation

a buy-and-hold

insurance, and option-based portfolio insurance strategies (23)

those with convex payoff curves under: (26)

b flat (but oscillating) markets

8.6 Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth

management and asset allocation (28)

by individuals (29)

ideal portfolio that provides: (29)

a the certainty of protection from anxiety

b the high probability of maintaining one’s standard of living

c the possibility of substantially moving upward in the wealth spectrum

during the examination (30)

8.10 Understand the impact of alternative investments, including real estate, executive stock options and human

capital on asset allocation of individual investors (31)

8.11 Describe and apply barbell and option based strategies in the context of asset allocation (31)

8.12 Discuss reasons why the performance of rebalanced equally weighted commodity futures portfolio should not be

used to represent the return of commodity futures asset class (32)

8.13 Explain why the three most commonly used commodity futures indices (GSCI, DJ-AIGCI, CRB) show different

levels of return and volatility over a common time period (32)

8.14 Explain how the returns of a single cash-collateralized commodity futures and a portfolio of cash-collateralized

commodity futures can be decomposed into various sources of return (33)

8.15 Discuss the four theoretical frameworks (CAPM, the insurance perspective, hedging pressure hypothesis, theory

of storage) used to explain the source of commodity futures excess returns (34)

8.16 Explain the concepts of contango, normal backwardation and market backwardation (35)

8.17 Calculate the roll yield of a commodity futures contract in backwardation or contango (35) Note: The 12th line

from bottom of the left column should read “if inventories are high, the convenience yield may be low.” 8.18 Discuss the importance of roll return in explaining the long-run cross-sectional variation of commodity futures

returns and the implication for investors (36)

8.19 Describe the relative importance of volatility of spot return and roll return in determining the volatility of

futures returns (36)

8.20 Describe the impact of inflation and unexpected changes in the rate of inflation on individual commodity

contracts, sectors, and diversified commodity portfolios and indices (36)

8.21 Explain how rebalancing and diversification can impact the geometric rate of return of a portfolio in comparison

to its arithmetic rate of return (38)

8.22 Discuss the effectiveness of tactical asset allocation in commodity portfolios using strategies based on

momentum and term structure of futures prices (38)

8.23 Argue against the use of nạve extrapolation of past commodities returns to forecast future performance and

discuss the importance of formulating forward-looking expectations (39)

8.24 Discuss the role of global commercial real estate in a strategic asset allocation setting (40)

8.25 Identify the components of the commercial real estate asset class and the relative advantages of direct real estate

investment and real estate investment trusts (REITs) (41)

8.26 Explain the historical performance and diversification benefits of select asset classes (41)

8.27 Compare the assumptions and results of the CAPM approach to the Black-Litterman approach when

determining forward-looking asset allocations (42)

8.28 Explain the seven caveats identified by the author as considerations for strategic asset allocation to global

commercial real estate (43)

TOPIC 9: Current Topics

and “contango.” (47)

potential determinants including anticipated production, consumption and seasonal factors (47)

type of strategy (48)

9.4 Describe the type of calendar-spread strategy Amaranth employed and explain the rationale for this strategy as it

relates to natural gas pricing (48)

9.5 Discuss the magnitude of Amaranth’s calendar-spread positions: explain how this hedge fund was able to accumulate such large positions (including the role of position limits) and describe the effects of the magnitude

of the positions on daily profits and losses (49)

liquidation in September 2006 (52)

spreads (52)

defined as the likelihood of experiencing severe loss), and explain how scenario analysis can be used to better

indicate the risk of a fund’s structural position in such circumstances (53)

9.9 Describe what is meant by “nodal” or “one-way” liquidity in the commodity markets and how the lack of

“two-way” liquidity adversely affected Amaranth (55)

9.10 Understand how forced liquidations can affect market prices and why changes in market prices can be correlated

with the size and direction of the liquidation (55)

9.11 Discuss eight hypotheses explaining the market events of August 2007 (56)

9.12 Illustrate an understanding of the terminology used to describe distinct categories of fund strategies that fall

under the broad heading of “long/short equity.” (57)

9.13 Describe the anatomy of the long/short equity strategy Explain how it is simulated in the paper, how the strategy provides liquidity to the market place, how leveraged portfolio returns are constructed, the relationship between market capitalization and the strategy’s profitability, and the practical implications of transactions

costs (58)

9.14 Explain the return pattern of the main simulated strategy during the second week of August 2007 (60)

9.15 Compare and contrast market events in August 2007 with August 1998 (60)

9.16 Explain how the increase in total assets under management and the number of long/short funds over the 1998 to

2007 time period likely impacted expected returns and the use of leverage (60)

9.17 Describe the set of hypotheses that are collectively referred to as the “unwind hypothesis.” (61)

9.18 Discuss one proposed measure of illiquidity of long/short equity funds and how the results have changed over

the past decade (61)

9.19 Describe a method for approximating a network view of the hedge-fund industry and what such a view

indicates (62)

9.20 Evaluate the statement: Quant failed in August 2007 (62)

9.21 Critique the methodology of the article (63)

9.22 Evaluate the current outlook for systemic risk in the hedge fund industry (64)

9.23 Describe a subprime loan and discuss the four principal reasons for the recent increase in sub-prime loan

delinquencies (64)

9.24 Explain the economic motivations that enabled the waterfall payment structure of an ABS trust or CDO structure with a collateral pool consisting of high-yield securities to attain an investment grade rating for the

securities they issued and the resulting contribution to the credit crisis (65)

9.25 Explain the role of rating agencies in the credit crisis (66)

9.26 Criticize the incentive compensation system for mortgage brokers and lenders and its adverse effect on the

due-diligence efforts at the firms (66)

9.27 Explain the factors affecting the rating of a special investment vehicle (SIV) (66)

9.28 Describe the role of monolines (67)

9.29 Explain the lack of incentives for banks to perform due diligence on the collateral pool (67)

9.30 Explain the role and actions of central banks in 2007 and early 2008 (67)

9.31 Explain the role of valuation methods (67)

9.32 Describe the lack of transparency in the credit markets (68)

9.33 Describe how systemic risk arose in 2007 (68)

9.34 Argue how increased transparency in the rating process is necessary (69)

9.35 Argue how standardization can simplify valuation issues (69)

9.36 Assess the hidden risks of implicit and explicit off balance-sheet bank commitments and argue how increased

transparency can provide investors with information regarding financial institutions’ exposure (69)

9.37 Describe how new product design can dampen market disruptions (70)

9.39 Describe sound risk management practices (71)

9.40 Describe nonlinearities in the risk of subprime CDO tranches (71)

TOPIC 10: Portfolio and Risk Management

10.1 Assess the long-run and short-run benefits of hedging the tail risk of a portfolio (73)

10.2 Explain the relationship between systemic risk, liquidity risk, monetary policy and other macro events (73)

10.3 Explain why increased correlation among various asset returns during periods of stress could provide

opportunities for free insurance against tail risk (74)

10.4 Describe the four approaches to hedging or insuring a portfolio against tail risk (74)

10.5 Explain why dynamic strategies such as portfolio insurance cannot be used to hedge against tail risk (74) 10.6 Describe the three factors that impact the construction of a tail hedge (75)

10.7 Explain why long-dated options may provide an inexpensive method for hedging tail risk (75)

10.8 Evaluate the factors that lead to the underpricing of risk by investors (75)

10.9 Explain the relationship between the real economy and capital markets and discuss the factors that have made

the real economy less volatile through time (76)

10.10 Discuss why capital markets are complex and adaptive and explain the implications of these characteristics for

models of risk measurement (76)

10.11 Compare and contrast the terms risk and uncertainty (77)

10.12 Explain the role of shadow banking system as a source of liquidity and discuss why during periods of market

stress this source of liquidity may disappear (77)

10.13 Demonstrate how cognitive biases can lead to errors in judgment by financial market participants (78)

10.14 Describe factors complicating the establishment and maintenance of target allocations to illiquid asset classes

(78)

10.15 Explain the role of Monte-Carlo simulation to achieve stable (steady-state) allocation in this study (79) 10.16 Illustrate the total impact of several individual risk factors on private equity allocation drift (79)

TOPIC 11: Research Issues in Alternative Investments

falling (81)

markets (86)

11.10 Describe the factors that cause smoothing and how smoothing impacts asset allocation decisions (86)

11.11 Compare the results of Stevenson (2004) with previous studies on the impact of smoothing models on

allocations to real estate (87)

11.12 Compare four approaches to generating an unsmoothed total real estate return series (87)

11.13 Describe the impact of varying smoothing parameters for UK real estate return data on the optimal allocations

to real estate (92)

11.14 In the Marcato and Key (2007) study, compare and contrast the results of using UK data with those employing

US and Australia real estate return data (92)

11.15 Argue the best method of adjusting a real estate return series when conducting an asset allocation study (93) 11.16 Describe the hedge fund business model presented by the authors (93)

11.17 Analyze the issues in measuring the growth of the hedge fund industry (94)

11.18 Evaluate the potential biases in hedge fund databases (95)

11.19 Review the approach and describe the main findings of bottom-up research on hedge fund risk factors (96)

11.20 Describe and assess the adequacy of the asset-based style (ABS) risk factor model used by Fung and Hsieh to

analyze hedge fund returns (98)

11.21 Discuss the broader risks associated with hedge funds and describe the regulatory concerns (99)

11.22 Describe the role of manager selection in the experience of a private equity investor (99)

11.23 Discuss the challenges that an investor would face in measuring the risk-adjusted performance of private

equity (100)

11.24 Explain the implication of the observation that mean and median returns on private equity databases are

significantly different (101)

11.25 Explain and identify the potential bias in using the performance of liquidated funds to represent the overall

performance of private equity funds (101)

11.26 Compare the performance of companies in which private equity firms invest with small cap firms listed on

NASDAQ (101)

11.28 Discuss the impacts of adjustment for stale prices on risk, return, and diversification benefits of private equity

(candidates do need to memorize exact figures) (102)

11.29 Identify the impact of IPO under-pricing on the performance of the PVCI (103)

11.30 Explain how the following issues pose a challenge to private equity investors: (103)

b Parameter uncertainty

c Absence of an investible index

d Cross-sectional differences in private equity managers

T O P I C 7

Structured Products, New Products

and New Strategies

Special purpose vehicles (SPVs) are used as the legal entities (e.g., trusts) that form the

center of every collateralized obligation (CO) structure “Collateralized obligations” is the umbrella term for a spectrum of asset-backed structures (e.g., collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs)) that hold debt obligations

as collateral and are financed with “tranches” or securities that typically have diverse seniority and/or longevity

The SPV is the entity that legally owns (holds) the collateral (the underlying debt, credit,

or other instruments), and is the entity that issues the various tranches that have claims to the cash flows (senior, mezzanine and equity)

The SPVs are usually Delaware based business trusts or special purpose corporations They

are referred to as “bankruptcy remote” This means that a bankruptcy of the sponsoring

bank or the money manager will not affect the functioning of the CO structure

The SPVs hold the collateral and distribute the cash flows from the collateral to the tranche holders

SPVs typically hold asset backed securities (ABS), which are bonds that are securitized

or collateralized by the cash flows from an underlying pool of assets—such as credit cards, home loans, auto loans, equipment leases, or other non-mortgage related assets

2 Describe the key characteristics of a collateralized fund obligation

(CFO)

Collateralized fund obligations (CFOs) are the application of the collateralized

obligation (CO) concept to investing in hedge funds and started in 2002 CFOs hold

portfolios of hedge funds and “repackage” the ownership of the portfolio into securities

or tranches with different levels of seniority and/or longevity

CFOs allow investors to participate in alternative investment opportunities (typically

with diversification) through a spectrum of CFO tranches with various maturities and risk

levels that are potentially more tailored to the preferences of the investor and more easily understood due to standardization and comparability to other similar programs The debt tranches may offer credit ratings and the equity tranches offer leverage

For example, a CFO might be formed that requires that the portfolio of hedge funds owned inside the CFO meet a number of minimum diversification requirements (e.g., 25

or more funds, 20 or more managers, no more than 10% with one fund, no more than 15% with one manager, etc.) The level of diversification is an important issue in determining the relative value (and credit ratings) of the tranches or securities that have claim to the cash flows generated by the portfolio

Tranches are securities sold to investors that represent claims to the cash flows from the portfolio The tranches are usually denoted with letter names and vary in seniority from very low risk senior tranches to an equity tranche with high risk For example, tranche

“A” might represent half of the value of the CFO, might offer a low coupon (e.g., LIBOR

plus 60 basis points), have semi-annual coupon payments and have first priority to the cash flows from the portfolio of hedge funds Given this high priority and substantial diversification of the portfolio's holdings, the tranche might receive a credit rating from a major agency of AAA

Less senior tranches would have higher coupons and lower credit ratings Finally, the equity tranche would be unrated and would receive the residual cash flows, if any, after the debt tranches have been satisfied Certain requirements such as a total net value might

be imposed which, if not met, trigger a liquidation (along with potential diversification and liquidity requirements) These liquidation triggers are designed, along with the diversification, to provide protection to the senior tranches so that they can be sold with high credit ratings

3 Explain the benefits and risks of investing in CFOs

Benefits to CFOs (collateralized fund obligation) to investment company managers that

manage the CFOs can include management fees, incentive fees and gains through ownership of the equity tranche

Benefits to CFOs (collateralized fund obligation) to hedge fund managers who view the

CFOs as investors in their hedge fund are that the money is less likely to be withdrawn

Hedge fund managers prefer investors that are relatively unlikely to withdraw funds

(“sticky” money rather than “hot” money) Using the CFO structure, investors in a tranche wishing to liquidate can sell their tranche without it affecting the CFO portfolio

and requiring a liquidation of a portfolio holding

Benefits of CFOs (collateralized fund obligations) to investors include the ability of

institutions such as pension funds, insurance companies and others to diversify into the hedge fund arena through ownership of tranches rated by a major rating agency Often, such institutions are prohibited from direct ownership of unrated investments such as a

hedge fund Further, CFOs have been shown to have lower systematic risk exposures

(due to their absolute return strategies) than other similarly rated investments (such as pools of corporate bonds) and so are less subject to general credit market events or other market wide events Anson reports the correlation of fund of funds returns with leveraged loans and high yield returns of only 35 and 43 Thus, investors can receive the benefits

of somewhat diversified risk exposures that contain less systematic risk (and perhaps more idiosyncratic risk related to funds manager skill)

Risks of CFO investing are generated from the risks of the assets (hedge funds) that

comprise the portfolio Anson analyzes historic returns to funds of funds and compares the return distributions to the distributions of high yield portfolios and leveraged loan portfolios Anson concludes that the past return distributions have been roughly similar The hedge fund of fund returns have moderate volatility and a good Sharpe ratio but have

a slight negative skew and slightly high kurtosis Therefore, CFO investors are exposed

to a relatively substantial risk of large negative returns However, as noted in the previous paragraph, the correlations of the returns with large credit market events may be

reasonably low and therefore CFOs provide diversification benefits

4 Describe the structure of a collateralized commodity obligation (CCO)

The concept of collateralized obligations (COs) has been extended into commodities with

a collateralized commodity obligation (CCO) being issued with rated tranches in 2005

The idea is to utilize a CO structure to facilitate exposure to commodity price risk

The commodity price risk is accomplished in the CCO using commodity trigger swaps

(CTSs) A commodity trigger swap is similar to a credit default swap except that the risk

to the principal is generated by falling commodity prices (rather than a credit event) The

CCO receives fixed coupons (much like insurance premiums) up to the maturity of the CTS at which time the CCO either receives the full principal of the CTS (if the

triggering event has not occurred) or nothing from that CTS if the triggering event has occurred The triggering event is prespecified For example, a triggering event might be if

a ten day average of a particular commodity price has declined more than 35% from the commodity price when the swap is set

The CCO contains a diversified portfolio of CTSs and must adhere to prespecified

diversification standards The result is a set of tranches that offer a spectrum of probabilities for full payment and an exposure to various commodity prices such that severe declines in one or more commodity prices could cause tranches to lose principal

(starting with the least senior tranches)

5 Describe the conceptual characteristics of infrastructure sectors

Mansour and Nadji describe six conceptual characteristics of infrastructure sectors Note that the set of characteristics of infrastructure investments is a main point of CAIA’s

curriculum Of particular interest here is the fact that infrastructure assets are highly heterogeneous, with no two infrastructure assets having identical attributes Another

crucial aspect is that the lifecycle of the infrastructure asset is a key determinant of the

asset’s performance

1 Monopoly: Infrastructure assets generally have very high initial fixed costs As a result, they are typically large-scale investments that can act as a barrier to entry for new entrants A consequence of this is that infrastructure assets have monopolistic or

“quasi-monopolistic” characteristics The article also notes that these assets have traditionally been funded by the government through general taxes or the municipal bond market that also indicates a barrier to entry for new entrants

2 Inelastic demand: Infrastructure assets provide essential services to the community and demand does not fluctuate with price movements or the business cycle Since infrastructure assets have few substitutes, they contribute to the inelastic nature of demand

3 Stable cash returns: The previous two characteristics – monopoly and the inelastic nature of demand – ensure that infrastructure assets have stable cash returns This is generally because infrastructure assets render essential services, the demand for which does not change with consumer sentiment

4 Long duration: As is the case with real estate, infrastructure assets last for a long time, often over 50 years The long lasting nature of infrastructure asset returns makes these assets very attractive to institutional investors Most public and corporate pension plans face long-term liabilities and the long lasting nature of these assets makes them very attractive to plan sponsors

5 Inflation hedge: Infrastructure assets can be classified as tangible, real assets and provide an inflation hedge The replacement costs of real assets increase in an inflationary environment, which preserves the value of existing infrastructure assets Rent escalations on infrastructure assets that are usually CPI-linked are permitted

6 Hybrid asset: Infrastructure assets share many common features with a variety of other assets such as real estate, fixed income, and private equity If the infrastructure asset is government regulated, the income streams are analogous to fixed income investments with the additional advantage of having inflation protection Developing infrastructure assets in India share common risk and return characteristics with opportunistic real estate development An infrastructure investment in an operating company that runs an airport is a common private equity strategy

6 Compare infrastructure with other traditional and alternative assets

Many institutional investors new to this asset class view it as a subset of commercial real estate – with physical, real, tangible assets generating cash flows But others view it as a substitute for long duration bonds with an embedded inflation hedge More generally,

infrastructure is a hybrid asset class and shares common features with many traditional

and alternative assets However, the bond-like, equity-like, and real estate-like features of

any infrastructure investment depends on the individual asset and the stage of the asset’s maturity See the exhibit below

Value-Added

Core Real Estate/Fixed Income

Opportunistic/Private Equity

Risk

Core Real Estate/Fixed Income Value-Added Opportunistic/Private Equity

Water

Source: Mansour and Nadji (2007)

7 Critique the evidence on the performance history for infrastructure investments

The performance history for infrastructure investments has several limitations These limitations include:

1 Limited Performance History

2 Expensive and often proprietary data collection

3 Lack of Appropriate Benchmarks

4 Significant variation within infrastructure investments given its hybrid nature

8 Explain how the composition and construction of the following indices impact their relative performance:

Note that the bulk of the material focuses on the UBS Index and Moody’s Economy.com Infrastructure Index Also note that benchmarking infrastructure investments is listed as a main point for this Learning Objective, and such investments

can be: listed infrastructure investments and unlisted infrastructure investments

The major indexes use listed companies in their construction The article also notes a study by Peng and Graeme (2007) that examined the performance of 19 major unlisted Australian funds

a RREEF Hypothetical Infrastructure Index

The RREEF was constructed based on the UBS index because the UBS index was not widely available on a global or U.S.-basis RREEF used the UBS-Europe Index as the base, stripping out companies that did not focus on direct infrastructure such as airlines and logistics Hence, the RREEF index has focused primarily on pure infrastructure plays

or “infrastructure operating companies.”

Since only listed companies were used, the volatility of this series was increased but could be directly compared to publicly-traded assets such as equities and securitized real estate It returned 12.5% per year with a 13.2% volatility, placing it between European bonds and equities

b UBS Global Infrastructure & Utilities Index

The UBS indices exist for the global and major regions of the world, including the U.S The Global series is based on a group of 85 companies

The UBS index is about 4.6% of the S&P Global Universe Integrated Utilities make up 52% of the index, Integrated Regulated Utilities make up 25% and Energy Transmission and Distribution make up 13% The remaining subsets are Power Generation (5%), Water (1%) and Other Infrastructure (including communication and transport) that make up 4%

On a 10-year basis, the UBS index averaged 12.7% less than private equity and public real estate but more than hedge funds, public equity, and fixed income returns The volatility at 18.3% has exceeded fixed income and hedge funds but trails public real estate and public equity

The index has showed low correlations with traditional and alternative assets

c Moody’s Economy.com Infrastructure Index

Five infrastructure sectors are included: Electricity (Distribution and Generation), Water (Treatment and Distribution), Communications, Transport, and Gas (storage and distribution)

The Electricity, Water, and Gas sectors are under Energy and Utility

Companies are market-cap weighted The Economy.com Index has a lower return than the UBS Index since its inception (5.3% for Economy.com versus 9.4% for UBS) It also has a lower volatility than the UBS Index (13.1% for Economy.com versus 19.3% for UBS)

9 Identify risks involved with infrastructure investments

Mansour and Nadji find six types of risks associated with infrastructure projects, including:

1 Construction Risk: Construction may be delayed or abandoned due to unforeseen risks related to weather

2 Operational Risk: Infrastructure projects may fail operationally if a chain of command does not exist and is not properly supervised

3 Leverage/Interest Rate Risk: Infrastructure investments may require additional borrowing of capital which subjects itself to interest rate risk

4 Regulatory Risk: Infrastructure projects may be exposed to regulatory risk if new laws inadvertently create new restrictions

5 Legal Risk: Infrastructure investments may be exposed to legal risk if, for example, they are to require land not yet acquired

6 Political Risk: International infrastructure investments may be exposed to the whims

of the government

Other considerations include liquidity, pricing and benchmarking

10 Explain the economic implications of climate change in terms of its

impacts on existing assets, future economic activity, increased

regulation, and consumer behavior

According to the latest Intergovernmental Panel on Climate Change (IPCC), global warming is a reality, and there will be an increase in the severity of weather around the globe Emerging and developing economies will be hit hard Initially, the human toll will probably be highest in countries such as India, Bangladesh, South and Central America

In developed countries, meanwhile, the economic toll will be higher The changes in climate will have many impacts: higher cost of capital, higher insurance costs, higher regulatory costs, and changes in consumer behavior that may have positive or negative effects

The increased uncertainty associated with the weather changes will affect the planning of future economic activity This will increase the risk premiums from the investments Companies that plan to build and invest in an area where the weather effects are higher can expect a higher cost of capital Furthermore, people planning to move to such areas can expect higher insurance premiums for homes and property

Regulations associated with the weather will increase costs However, certain industries are likely to benefit: e.g construction, renewable energies, and mechanical and electric engineering as companies attempt to meet the new regulations

Climate change can also have an economic impact on consumer behavior Evidence suggests that consumers are conserving energy and cutting back on climate harming activities and supporting compensation measures

11 Describe the role of financial markets in reducing the economic cost of climate change through:

There are two basic approaches for dealing with climate change: abatement strategies and adjustment strategies Abatement strategies attempt to prevent climate change

Adjustment strategies react rationally to the unavoidable consequences of climate

change

Financial markets and suitable financial instruments can help finance climate-related technology and distribute weather risks efficiently The following list summarizes the roles of financial markets

a markets for catastrophe and weather risks

The market for catastrophe risks and weather risks offers adjustment strategies These

are instruments that provide compensation for certain events Such instruments include

catastrophe risk transfer instruments such as catastrophe bonds and weather

derivatives, which involve a cash flow when a certain event occurs There are also sharing arrangements for unavoidable natural catastrophes and weather risk, which can reduce the individual cost of coverage

risk-The effect of these instruments is an efficient sharing of the risks that come from unavoidable natural catastrophe and weather risks This lowers the cost of covering individuals The markets also provide information such as price signals concerning environmental threats

b emissions trading

Emissions trading is part of an abatement strategy The strategy sets a limit on the

amount of pollution across the economy by issuing a limited supply of emission certificates These certificates can be traded, which gives each corporation an incentive to produce less pollution because it can sell unused emission certificates

Additional benefits may result from derivatives on those certificates and the existence of funds and other investment vehicles that invest in emission certificates

The goal of emission trading is to minimize the costs associated with greenhouse gas emission reduction However, there is an ongoing debate concerning the potential benefits and functioning of the emissions trading market

of this strategy

There are a wide variety of companies in which to invest, e.g., those in the energy industry, those that are developing and producing climate protection-relevant technologies, those that are applying climate protection-relevant technologies, and those that offer solutions for adapting to climate change This strategy would be enhanced by a political and regulatory framework that reduces the cost of debt and equity financing for the companies Increased investor awareness would lower perceived risk and the cost of

capital

12 Explain the economic rationale for using financial instruments to

transfer risk

The general economic rationale for having financial instruments to transfer risk is that risk sharing by agents in the economy can reduce shocks to the overall economy For one thing, a decline in business for any sector will reduce tax revenues, and there will be a drain on government funds in repairing the infrastructure The following list provides more details

● Coverage of large volumes: Natural catastrophes and extreme weather events can cover large areas so that the potential losses are above the levels that a single firm or even government can afford The financial instruments would provide payoffs to help supply capital to cover losses

● Efficiency and transparency: The market can break down the risk into small pieces and distribute them among qualified investors This would reduce the concentration

of risk among a few insurers, and the risk levels would be more transparent Market participants would price risk to include all relevant information, which would increase efficiency

● Uncorrelated asset class: The new instruments would provide a new tool for increasing diversification of investment portfolios This is especially true because weather-related events typically have a low correlation with market returns

● Macroeconomic benefits: Firms can hedge risks and increase output, which helps the overall economy Market efficiencies should lower the cost of hedging and increase macroeconomic benefits further

13 Discuss the criteria that need to be fulfilled by instruments employed for risk transfer

There are five basic criteria for instruments to be effective in transferring risk

1 Measurable and calculable risk: There must be estimates of both losses and probabilities in order to price the instruments, which would most likely come from historical data

2 Affordable risk premium: For the party seeking protection, the risk premium must be affordable while still covering the potential losses

3 Reliable payment trigger: To minimize conflicts of interest, there should be a precise definition of the event that triggers payment The payment trigger must be transparent, reliable, and difficult to manipulate

4 Avoidance of moral hazard and adverse selection: There should be information symmetry This would lower the adverse selection problem where high-risk firms seek coverage at the average market price Information symmetry would lower the potential for the moral hazard problem in that the covered firm would want to inflate losses

5 Development of adequate pricing models: Traditional pricing models would require

modification to price catastrophe risks and weather risks Weather data is very

different from traditional market data, for e.g., weather data has a seasonal element

Furthermore, catastrophe data is sparse, and all the outcomes are not known These and other considerations would have to be included in the pricing models

14 Describe existing instruments that can be used to transfer risk and

identify potential investors and sponsors of these instruments

The following list describes the existing instruments that can be used to transfer

catastrophe and weather risks Catastrophe bonds and exchange-traded contracts are

fairly liquid, and the other instruments are tailored to meet the needs of certain entities and are usually held until maturity

Catastrophe bonds (cat bonds): The coupons are usually based on LIBOR plus an

appropriate risk premium, and when a predefined loss occurs, the investor forfeits the capital invested Special purpose vehicles (SPVs) usually issue the bonds and invest the proceeds in traditional fixed income securities to cover contingent claims by the sponsor

Cat-risk CDO (Collateralized Debt Obligation): The various catastrophe risks are

bundled and sold in individual risk tranches One or more events must occur before the investor suffers a loss

Capital market-financed quota share reinsurance, known as sidecars: In this contract, the investors share proportionally in a loss according to a predetermined quota This uses tranches as well, and there is at least one debt and equity tranche

Industry loss warrants (ILW): This market, that has been around for a while, is usually in

the form of private placements It is a type of capital market-financed loss (re-)insurance, which is linked to an industry loss index

Event loss swaps (ELS): These are a variant of conventional ILWs They are more tradable

because they are more highly standardized

Catastrophe swaps (cat swaps): These are contracts where two insurers can swap generally uncorrelated risks, such as those between different regions or industries

Contingent capital arrangements: This category is composed of types of put options

The option buyer has the right to raise debt or equity capital or sell assets under specific terms if a given loss occurs One use of this would be by a firm that would want to make sure it has adequate capital in the event of a loss They were popular in the 1990s, but because they are difficult to price, they are not used much today

Exchange-traded contracts in catastrophe risks: Some cat futures and cat options trade

on an exchange They started in the early 1990s, but turnover was small There have been moves to modify the contracts to generate more interest Since they trade on an exchange, they offer more liquidity, and they would be used by entities where liquidity is important

The investors in these instruments must be knowledgeable, which limits potential investors to insurers and reinsurers, institutional investors, and hedge funds Insurers and reinsurers use the contracts as part of their overall portfolio strategy Hedge funds make investments to earn the premiums Mutual funds using these instruments are being developed so that more investors can participate

The “sponsors” are those that issue the contracts for protection The largest sponsors are insurers and reinsurers, corporations with a high exposure, and government insurance and development funds Insurance companies that have taken on the risks of companies with insurance contracts are a large group of sponsors that use the contracts to manage their risk Corporations with high-risk exposure naturally hedge risk so they can focus on their business There are government insurance and development funds in many countries that are sponsors, e.g., Mexico’s natural catastrophe fund (FONDEN) recently transferred large amounts of earthquake risks to

the capital markets using catastrophe bonds

15 Describe both exchange traded as well as over-the-counter weather derivatives

The market for weather derivatives is concerned with relatively low-cost high probability

events This is in contrast to the market for catastrophe risks that covers high-cost low

probability events Weather derivatives pay off when there are unusually low or high temperatures A natural gas company may wish to hedge against a warm winter, for example, which lowers the quantity demanded of natural gas used for heating

In the OTC market, the contracts are negotiated individually and with properties specified

by the counterparties These contracts began in the mid-1990s Tradable weather-related futures and options have been on the Chicago Mercantile Exchange (CME) since 1998 Other exchanges have offered these products, but have discontinued them for now, through some are planning to introduce new products As of now, however, the CME is the only exchange where weather-related futures and options trade, and the exchange plans to expand its offering Market participants find that the exchange-traded products have a lower cost and higher liquidity There has been an increase in the turnover in exchange-traded contracts at the CME relative to that of the OTC market

16 Describe emissions trading, its project-based mechanism, and its

potential market participants

The biggest market for greenhouse gas emissions is the EU Emission Trading System (EU-ETS) The EU-ETS uses targets proposed by the Kyoto Protocol, which defines a

number of different emission certificates There is a distinction, for example, between

emission rights and emission credits There are a limited number of emission rights for

all companies, and these rights can be traded among companies that emit the greenhouse gases This is referred to as cap and trade, in that there is a limit or cap to the emissions

and the right to emit can be traded The limited number includes the EU Allowances (EUAs), traded in the EU-ETS, and includes the assigned amount units (AAUs) that

trade internationally

With respect to emission credits, on the other hand, investors can have credits from

additional climate protection projects that are in other countries credited to their own

reduction target (baseline and credit) Also, with respect to emission credits, there is a

difference when the reductions take place in an industrial country or in an emerging market For the industrial country, the resulting certificates are called emission reduction

units (ERUs) For emerging markets, they are called certified emission reductions (CERs)

The Kyoto Protocol also allows for the realization of carbon-sink projects at home such

as afforestation This is done with the use of removal units (RMUs) Also, it is possible

to generate tradable project-based credits called verified emission reductions (VERs) They differ from CERs and ERUs in that VERs can only be used for voluntary CO2 compensation

The CERs and ERUs are useful for the exceptions the Kyoto Protocol extends to emerging markets This is because emerging markets are exempt from greenhouse gases quantitative reduction commitments The Kyoto Protocol’s project-based mechanisms allow the CERs and ERUs from additional climate protection projects in third countries

to be credited to the owner’s reduction target within certain limits, e.g., down to 50% of the initial target

The Clean Development Mechanism (CDM) of the Kyoto Protocol allows for

investment to be made in a project that promises to yield future income in the form of CERs A wide variety of projects qualify, and the CERs can be generated from a portfolio of projects The rights to future CERs are traded at a discount, which is a function of the project’s stage of progress A less advanced project would have a higher discount

Potential market participants include carbon funds, which include government

purchasing programs and private commercial funds The Prototype Carbon Fund (PCF), launched by the World Bank, was one of the earliest funds It gathered experience with the new emissions trading instruments and prepared the market for later funds An increasing number of investment banks, brokers and institutional investors are buying and selling certificates for their own or third-party accounts; however, companies that have to meet reduction commitments within the EU-ETS framework are still the biggest group of end buyers (compliance buyers)

Investors who have no direct involvement with emissions can attempt to earn a positive

return in the market for these types of instruments Carbon funds offer advantages over a

direct investment because the funds have an expertise in the area, offer diversification, and can allow the investors to take on a particular level of risk via the number of shares purchased in the fund

There has been increasing product differentiation, and new possibilities are opening up for investors Investors can place bets on rising prices through derivative instruments on

emission certificates or participate in the realization of CDM projects

17 Compare the factor-based approach to hedge fund replication with

the payoff distribution approach to hedge fund replication, in terms of their:

a goals

The ultimate goal of both the factor-replication approach (or the factor-based

approach) and the payoff distribution approach is to create a portfolio with

characteristics similar to a particular hedge fund, for e.g., to have the same risk profile, and earn returns similar to those of the hedge fund at a lower cost To

achieve that ultimate goal, the factor-based approach has the goal of replicating the hedge fund’s returns using hedge fund risk factors The payoff distribution

approach attempts to replicate the hedge fund’s returns by matching the

unconditional higher moments, which should then give the same first moment, i.e., the same average return

b methodology

The factor-based approach focuses on the conditional distribution to earn the

conditional mean of a hedge fund, given values of the underlying risk factors This requires a two-step approach

Step 1 requires the calibration of a satisfactory factor model for hedge fund returns This

is essentially estimating a factor model:

Hedge Fund “k” Returnt = B0 + B1F1,t + B2F2,t + + BNFN,t + et where each Fi,t is the value of factor “i” at time “t”, and each Bi is the corresponding factor sensitivity

A stepwise regression is often used in this process, but it does not allow for the researcher

to make inferences A stepwise regression is a regression technique that allows for forward selection of relevant factors or backward elimination of irrelevant factors Forward selection starts with no factors and, at each step, the most significant factor is added to the model Backward elimination starts with a set of factors and, at each stage, the least significant factor is removed

Another approach is to use a conditional factor model which allows the coefficients, Bi,

to be time varying, too The goal is to capture time varying factor exposures Another

approach is to use non-linear factor models that may also be able to better capture the relationship and make better out-of-sample forecasts

There is also return-based style (RBS) analysis, which examines the exposure of hedge funds to certain style factors While this approach allows for lower specification risk, the key issue is the efficacy of the factors in building mimicking portfolios

Once having chosen a particular methodology in Step 1, Step 2 requires the identification

of the replicating factor strategy (RFS), which is creating a clone of the hedge fund return using the estimated coefficients and the out-of-sample values of the factors

The payoff distribution approach focuses on creating a clone portfolio where, for all x,

Pr(Clone return<x) = Pr(Hedge Fund return < x)

This also requires a two-step process: Step 1 consists of estimating a payoff function that maps an index return onto a hedge fund return Step 2 consists of pricing the payoffs and deriving the replicating factor strategy, which is done using the Merton (1973) replicating portfolio interpretation of the Black and Scholes (1973) formula

c ability to replicate hedge fund returns

The factor-based approach, while the most natural and straightforward way to approach

the replication problem, has failed in thorough empirical tests to produce satisfactory

results on an out-of-sample basis The payoff distribution approach produces satisfying

results for long-run out-of-sample returns but cannot capture short-run time-series properties Also, the approach does not attempt to match the first moment (the mean), which is crucial to any investment analysis

d benefits

The factor-based model addresses the essence of the problem, which is to find details of

the risk exposures The payoff distribution approach has the benefit of doing a better

job of replicating return, at least, in the long run

e drawbacks

Neither approach has produced satisfactory results With the factor-based approach,

there is a difficulty in identifying the correct factors and replicating the dynamic exposure

to the factors We should recall that simple regression techniques only capture the past average exposures of the managers

Also, any factor analysis can suffer from specification risk This is the result of not using

an accurate mix of factors Either the omission of factors or including too many factors can lower the accuracy of the model

The payoff distribution property has some success in replicating long-run returns However, it fails to replicate the short-run time-series characteristics

18 Discuss the term convergence as it is applied to the alternative

investments industry

The term convergence is used to define the blurring of the lines between hedge fund and

private equity investing In this context, the authors refer to actual transactions pursed by both hedge fund managers as well as private equity managers The objective of both hedge fund and private equity investors is to pursue “manager skill” or “alpha” rather than market exposure

19 Compare and contrast the historical objectives of private equity funds with that of hedge funds

There are several distinctions in the historical objectives of hedge fund managers versus private equity managers, as noted by the authors The exhibit below classifies these objectives into three categories (Securities employed, Strategy pursued and Sources of returns) and compares these objectives

Distinction Hedge Fund Private Equity

Sources of

Return

1 Arbitrage Opportunities,

2 Superior Security Selection

3 Provision of Liquidity not generally available to the Market

1 Control of the Underlying Business Strategy and Management

Composition

2 Alignment of Economic Interests

of Management and Shareholders and

3 Access to types of Non-public information that listed share investments cannot provide

Source: Gonzalez-Heres and Beinkampen (2006)

20 Contrast recent hedge fund participation in traditional private equity

activities with recent private equity participation in traditional hedge

funds activities

Gonzalez-Heres and Beinkampen note that hedge funds use side pockets within existing

hedge fund vehicles to participate in private equity activities Hedge funds also establish

direct lending businesses that function much like a bank or mezzanine fund

In contrast, private equity funds set up units under the same roof to pursue hedge fund

investing The authors mention five examples Some have detailed information on their

websites These include:

1 Blackstone Group (http://www.blackstone.com/company/index.html): A private equity

specialist, with five general private equity funds and one specialized fund focusing on

media and communications-related investments Blackstone also manages hedge funds

such as Blackstone Kailix Advisors that invests primarily in equity investments on a

long and short basis

2 Texas Pacific Group (http://www.texaspacificgroup.com/): A global private

investment firm with over $30 billion of capital under management It manages a

family of funds including private equity, venture capital and public equity and debt

investing

3 Fortress Investment Group (http://www.fortressinv.com/): A private equity specialist

that makes significant, control-oriented investments in North America and Western

Europe, with a focus on acquiring and building asset-based businesses with significant

cash flows It also runs hedge funds: hybrid hedge funds and liquid hedge funds

4 Bain Capital (http://www.baincapital.com): A private investment firm whose affiliates

manage over $50 billion in assets It has investments in private equity and venture

capital as well as long/short public equity, credit products, and global macro hedge

funds

5 H.I.G (http://www.higcapital.com/): A private investment specialist that manages private equity, venture capital, distressed debt, and public equities products

21 Explain why the distressed investment space provides an excellent

example of recent convergence of hedge fund and private equity

strategies

The distressed space provides an excellent example of recent convergence because both

hedge fund investors and private equity investors have expanded their mandates

A typical distressed hedge fund manager evaluated investment opportunities more like a debt investor and invested in publicly traded securities He/she may or may not have played a significant role in negotiating a restructuring of the issuing company The objective was to identify securities of companies at various stages of the bankruptcy process (including companies on the verge of filing for bankruptcy or just emerging from bankruptcy), that are publicly traded at a discount to their intrinsic values Exit generally came through selling the appreciated security in the public market or to a strategic

acquirer Capital was in lock-up status for one or two years

Private equity managers, on the other hand, are “active” investors that typically acquire a majority interest in a company in order to get operating control and run the business The key difference is that they play a significant role in the operational turnaround and restructuring of the issuing company They often sell the company at a much later date for

a profit via an initial public offering (IPO) or sale to strategic investors

However in recent times, hedge fund managers have expanded from “passive investing”

to “buy-to-own” investing They are now acquiring sizable stakes with the mindset of owning the business rather than trading the securities They have also taken a “lend-to-

own” debt financing approach This entails providing debt financing, usually to highly

levered companies and in situations where the fund is indifferent about whether return is generated from interest or principal repayments or from a hands-on operational turnaround if the company defaults

Private equity fund managers, on the other hand, are increasingly taking “toehold

positions” in order to identify opportunities Even if they are ultimately unsuccessful in

gaining control, they recognize that material gains can be realized from these toehold

positions In other words, they are poaching each other’s strategies

22 Describe the emergence of the hybrid hedge fund/private equity fund

While Gonzalez-Heres and Beinkampen offer some general observations, they specifically describe a multi-billion-dollar hedge fund manager that their team has had a longstanding relationship with since the mid-1990s This manager is a multi-strategy manager The manager started out as a convertible arbitrage manager but transformed

into a passive distressed manager by the end of 2001 and then morphed into a hybrid

fund over the last 18 months The authors note that this was done by investing away from

liquid distressed debt situations and toward more illiquid private assets, ranging from small- and mid-sized companies to physical aircrafts Currently, the fund is approximately one-third private equity and two-thirds hedge fund

During the 2001-2002 period, there was a large wave of corporate bankruptcies The manager took advantage of these opportunities by focusing on passive (non-operational) hedge fund-style distressed investing By mid-2004, when these opportunities vanished, this manager felt that there were “gaps” that were overlooked by both hedge fund and private equity managers These situations, however, required three to five years to produce attractive returns After conferring with investors and getting their consent, the manager shifted towards a more private equity-oriented approach

In the situations above, the ability of the manager to adapt and migrate quickly to where the opportunities lay, led to strong returns The ability to offer both hedge fund and

private equity products are referred to as hybrid funds The authors note that in late 2005

and early 2006, several private equity managers that they had longstanding relationships with indicated a desire to launch “sister” hedge fund products Research conducted by private equity managers as they seek opportunities often led them to uncover opportunities in public markets Alternatively, large positions in private companies often may lead managers to discover unique insights into the health and stability of other companies or industries

23 Discuss the factors that contributed to the convergence of private

equity and hedge fund strategies referencing recent trends in the area

There are several factors that have contributed to the convergence of private equity and hedge fund strategies

First, the surge of capital that has flowed into hedge funds and away from private equity has put downward pressure on returns It has also forced managers to look into private equity opportunities where venture capital slowed significantly after the Internet bubble burst in 2001

Second, because corporate defaults since 2004 have been at near historical lows, opportunities for distressed and private equity managers have been limited

Third, the limited opportunities have led distressed hedge fund managers to pursue other opportunities such as leveraged buyouts A record $149 billion was raised for leveraged buyouts in 2005 Hedge fund managers watching these capital flows have been encouraged by some of the enthusiasm in this space

Fourth, private equity funds have been able to persuade corporate boards to back their transactions using the allure of stable capital, significant savings in time and money, and the avoidance of scrutiny that comes with going private This is because the corporate board of a private company is no longer compelled to comply with the Sarbanes-Oxley Act, nor does it have to answer to a multitude of shareholder constituencies

Fifth, the compensation structure of many hedge funds provides incentives for the fund to invest in higher yielding, illiquid securities traditionally purchased by private equity firms over the short term Unlike private equity firms where the manager is typically paid a performance fee only after all invested capital is returned to investors, hedge funds have traditionally been compensated on an annual basis

The authors also describe a sixth factor regarding SEC registration that is now mute The CAIA® Level 1 Study Guide includes the following study tip (under Topic 23: Regulation

of Hedge Funds): “…in December 2004, the Securities and Exchange Commission (SEC), by a vote of 3-2, promulgated regulations 203(b)(3)-2, an amendment to the Investment Advisers Act of 1940 (Advisers Act), which required many hedge fund managers to register with the SEC for the first time However… on June 23, 2006, the United States Court of Appeals for the District of Columbia overturned this regulation ”

24 Discuss the concerns and risks related to the trend toward convergence

of hedge fund and private equity fund strategies

There are several risks related to the trend toward convergence These include

1 Mismatch of liquidity provisions and investment skill sets,

2 Diversification (so that investors do not find themselves with one or two illiquid investments), and

3 Appropriate staffing to trade, finance, restructure and, if necessary, operate underlying investments

The authors note that as hedge funds realize the impact that their capital can have on the management of public companies, excesses could arise but few high profile conflicts are anticipated Hedge funds need to have appropriate staffing to operate underlying investments, if necessary, duties that have not traditionally fallen on a hedge fund manager’s modus operandi

Anson, M.J.P “Collateralized Fund Obligations: Intersection of Credit Derivative Market and Hedge Fund World.” Chapter 25 in Handbook of Alternative Assets, 2nd edition Edited by Frank J Fabozzi John Wiley & Sons, 2006

Mansour, A., and H Nadji “Performance Characteristics of Infrastructure Investments.” RREEF Research – A Member of the Deutsche Bank Group August 2007

Weistroffer, C “Coping with Climate Change.” Deutsche Bank Research November 15, 2007 Amenc, N., W Gehin, L Martellini, and J.C Meyfredi “The Myths and Limits of Passive Hedge

Fund Replication: A Critical Assessment of Existing Techniques.” Journal of Alternative

Investments Fall 2008

Gonzalez-Heres, J., and K Beinkampen “The Convergence of Private Equity and Hedge Funds.”

Morgan Stanley’s Investment Management Journal Vol 2, No 1, 2006

T O P I C 8

Asset Allocation

 M a i n P o i n t s

 Comparing and contrasting buy-and-hold, constant mix, and

constant-proportion portfolio insurance strategies

 Applying a wealth allocation framework that accounts for various dimensions

of risk and deriving an ideal asset allocation for an individual

 Interpreting the term structure of futures prices, the components of futures returns for individual contracts, returns for portfolios constructed and

rebalanced with various methods, and the implications of tactical asset

allocation strategies using commodity futures contracts

 Critically examining the methods of including global commercial real estate in

a strategic asset allocation

­ 1 Calculate the portfolio’s asset values after a given change in the

equity value, using:

a buy-and-hold

Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity) There are three primary strategies discussed as summarized below:

Up Market

Rebalancing in Down Market

Shape of Payoff

v Stock Market

Buy-and-hold None None Linear

Constant Mix Sell Stock Buy Stock Concave

Constant Proportion

 Consider for example an investor with $100 starting value allocating all of the funds between two choices: risk free bonds (interest rate equals zero for simplicity) and a single risky portfolio (the stock market) Assume that the investor’s initial allocation is to put

$70 in stock and $30 in bonds The stock market is indexed to 100.0

Under a buy-and-hold strategy there is no rebalancing The “Up” panel below shows the

value of the portfolio in an up market with the market index rising

10 points each period for three consecutive periods The “Down” panel below shows the value of the portfolio in an analogous down market Any funds used to purchase stocks come from bonds and vice versa

“Up” Market Panel: Buy-and-hold:

Time Stock Level Bonds Stocks Stock Bought(+) or Sold (-) Bonds Stocks Total

“Down” Market Panel: Buy-and-Hold:

Time Stock Level Bonds Stocks Stock Bought(+) or Sold (-) Bonds Stocks Total

 Note that there are no transactions since the strategy is buy and hold Further note that the

total value is linear – it changes by the same dollar amount for each equal dollar movement in the stock market The value of the portfolio (last column on right) changes

$7 for each 10 point change in the stock market index when it is 70% initially invested in the stock market and there is no rebalancing

b constant mix

Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity) There are three primary strategies discussed as summarized below:

Up Market

Rebalancing in Down Market

Shape of Payoff

v Stock Market

Buy-and-hold None None Linear

Constant Mix Sell Stock Buy Stock Concave

Constant Proportion

Under a “Constant Mix” strategy there is periodic rebalancing such that the portfolio is

returned to being, in this case, 70% stocks and 30% bonds The “Up” panel below shows the value of the portfolio in an up market with the market index rising 10 points each period for three consecutive periods The “Down” panel below shows the value of the portfolio in an analogous down market Any funds used to purchase stocks come from bonds and vice versa

“Up” Market Panel: Constant Mix:

“Down” Market Panel: Constant Mix:

Very importantly, note that the total value is non-linear – it changes by smaller dollar amounts for each equal upward dollar movement in the stock market The value of the portfolio rises $7 for the first upward 10-point change in the stock market index but rises by only $6.81 for the second 10-point change (the rebalanced stock holding does not rise by $7 because the 10-point stock rise is a smaller percentage stock price rise than it was when the stock level was lower) Conversely, rebalancing to the stock market while it is falling produces larger losses than in previous periods or in the buy-and-hold strategy (note that each 10-point decline in the market index represents a higher percentage decline)

Viewed on a graph with total portfolio value on the vertical axis and stock market index

values on the horizontal level, the Constant Mix strategy forms a concave shape The

buy-and-hold strategy forms a straight line

c constant-proportion portfolio insurance

Perold and Sharpe consider various rebalancing strategies between a risk free bond and the stock market (with interest rates set to zero for simplicity) There are three primary strategies discussed as summarized below:

Up Market

Rebalancing in Down Market

Shape of Payoff

v Stock Market

Buy-and-hold None None Linear

Constant Mix Sell Stock Buy Stock Concave

Constant Proportion

Under a “Constant-Proportion Portfolio Insurance” (CPPI) strategy the investor sets a

floor value at which all risky investing terminates Further, the investor increases risky

assets holding when the market rises and decreases risky asset holdings when the market falls

 For example, consider that the investor sets a floor value of $50 but invests 150% of the total portfolio value in excess of this floor in stock Thus, the investor starts with a total value of

$100 allocated $25 to bonds and $75 to stock At the end of each period, the investor resets the stock allocation so that it is 150% of the excess, if any, by which the total portfolio exceeds the floor ($50) Any funds used to purchase stocks come from bonds and vice versa

“Up” Market Panel: CPPI:

“Down” Market Panel: CPPI:

to insure that the floor value ($75) is protected

Very importantly, note that the total value is non-linear – it changes by larger dollar amounts for each equal upward dollar movement in the stock market The value of the portfolio rises $7.50 for the first upward 10-point change in the stock market index and rises $7.84 for the second 10-point change (since the strategy placed 150% of “profits” in stock) Conversely, rebalancing away from the stock market while it is falling produces smaller losses than in previous periods Over the long-term, the floor should increase, so that the relationship between the initial floor and a floor at time “t” is

Ft =F0ert where Ft, F0, r, and t are are the floor value of the portfolio at time t, the floor value at initiation of the strategy (t=0), the risk-free rate, and a time index

At a given point in time, viewed on a graph with total portfolio value on the vertical axis and stock market index values on the horizontal level, the CPPI strategy forms a convex

shape The buy-and-hold strategy forms a straight line and the constant mix strategy

forms a concave shape

2 Compare the payoff and exposure diagrams of the buy-and-hold,

constant mix, constant-proportion portfolio insurance, and

option-based portfolio insurance strategies

A payoff diagram in the context of the article by Period and Sharpe, is a graph of the relationship between total portfolio (asset) value on the vertical axis and stock market index value (performance of the risky asset class) on the horizontal axis Simply put, it tells the investor the profit and loss of his or her entire portfolio in relationship to movement in the stock market

 For example, consider a buy-and-hold strategy that purchases a particular combination

(e.g., 50%/50%) mix of a risky asset (stocks) and a risk free asset (bonds) The bond

values are assumed constant and for simplicity do not even pay interest The

buy-and-hold strategy does not rebalance, so the stock position simply grows and shrinks linearly

with the stock market as depicted below The slope of the line depends on the original mix, but the relationship is linear regardless of initial mix

Buy & Hold

Now consider a Constant-Proportion Portfolio Insurance (CPPI) strategy that buys stock in a rising market and sells stock in a declining market (to protect a floor value)

The payoff diagram will demonstrate a convex relationship as indicated below:

Value of the Stock Market

Finally, consider an option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market (to protect a floor value) The payoff diagram will demonstrate a kinked

but otherwise linear relationship similar to the traditional diagram of a call options and as indicated below:

Option-based portfolio insurance strategy that owns a constant

stock position in a rising market and sells all stock if a lower floor is

reached in a declining market

Value of the Stock Market

 In summary, the key to the payoff diagrams is that they show the linearity, concavity, convexity and call-option-like relationships of the four strategies as reviewed above These shapes are important in understanding behavior in trending versus reverting markets

An exposure diagram in the context of the article by Period and Sharpe, is a graph of

the relationship between desired stock position (amount of risk) on the vertical axis and total portfolio value on the horizontal axis Simply put, it tells the investor the risk exposure of the portfolio in relationship to the total portfolio’s cumulative performance

 For example, consider a buy-and-hold strategy that purchases a particular combination (e.g., 50%/50%) mix of a risky asset (stocks) and a risk free asset (bonds) The bond values are assumes constant and for simplicity do not even pay interest The buy-and-hold strategy does not rebalance, so the stock position simply grows and shrinks linearly with the stock market with a lower bound equal to the bond position as depicted below The location of the line on the horizontal axis depends on the original mix and bond position but is linear regardless of initial mix The key to the diagram is that it has a moderate slope

Buy & Hold

Constant proportion strategy

Now consider a Constant-Proportion Portfolio Insurance (CPPI) strategy that buys stock in a rising market and sells stock in a declining market (to protect a floor value) The exposure diagram will demonstrate a steeply sloped relationship as

Value of the Total Portfolio

Finally, consider an option-based portfolio insurance strategy that owns a constant stock position in a rising market and sells all stock if a lower floor is reached in a declining market (to protect a floor value) The exposure diagram will demonstrate a

steep and curved relationship as indicated below:

Option-based portfolio insurance strategy that owns a constant stock

position in a rising market and sells all stock if a lower floor is reached

Value of the Total Portfolio

3 Determine the expected performance and cost of implementing

strategies with concave payoff curves relative to those with convex

payoff curves under: a trending markets b flat (but oscillating)

markets

Concavity in the context of the Perold and Sharpe study refers to the tendency of a strategy to decrease equity exposure (risk) as the equity market rises and to increase

equity exposure as the equity market falls An example is a constant mix strategy that

sells stock in a rising stock market to keep the stock’s value a constant proportion of the portfolio Convexity refers to the tendency of a strategy to increase equity

exposure (risk) as the equity market rises and to decrease equity exposure as the

equity market falls An example is a CPPI (Constant-Proportion Portfolio

Insurance strategy) that is highly aggressive with profits, but is quick to reduce stock

exposure when nearing a lower bound “floor” value

The expected performance of a strategy is directly associated with the strategies’ payoff

curves A linear (buy-and-hold) strategy simply makes or loses money based on the terminal

performance of the underlying stocks However, concave strategies perform relatively well in flat (but oscillating) markets while convex strategies perform well in trending markets

a trending markets

A trending market works in favor of a convex strategy because as markets rise the stock exposure is greatly increase, producing high relative profits if the up trend is substantial and sustained Conversely, in a downtrend the stocks are sold off, mitigating the losses A concave

strategy’s relative performance is the opposite A concave strategy such as a constant mix

strategy liquidates stocks into a rally and buys additional stock throughout a long decline

b flat (but oscillating) markets

A flat but oscillating market favors concave strategies and hurts convex strategies A concave strategy will buy after a decline (e.g., to keep a target mix) and then profit in a reversal A convex strategy will get whipsawed – selling after the decline and buying after the rise Thus, the curvature explains the expected performance and costs of the strategy due to the subsequent nature of the market in the sense of whether the market will tend to trend more, or oscillate more

The following equations can help in describing the payoffs and equity weights for the various strategies The role of the variance in the constant proportion strategy is evident from the payoff equation for that strategy:

Vt = Ft + (V0 - F0) [(It/I0) m]e(1-m)(r+0.5*m*variance)twhere Vt, Ft, It, m and r are are the value of the portfolio, the floor value of the portfolio, the value of the market index, the multiplier, and the risk-free rate, respectively The subscripts 0 and t stand for the beginning value and the value at time t respectively

The amount of equity (risky assets) held in the CPPI strategy is:

Equity = m (At – Ft),

or Equity = MIN(A, m( At – Ft)) if no leverage is allowed

For the buy-and-hold strategy, the payoff equation reduces to

Vt = Ft + (V0 – F0)(It/I0), and the amount of the equity held is

Equity = (At – Ft)

4 Discuss the motivations for and impact of resetting the parameters of dynamic strategies

Parameters of dynamic asset allocation strategies can adjust exposures to risky assets at

various levels, can adjust minimum desired asset levels (cushions and floor values) and

so forth Some dynamic strategies, such as option-based portfolio insurance, require resetting of parameters at horizon points Other dynamic strategies such as constant mix

require transactions but not resetting of parameters

By adjusting the parameters, the risk exposures and payoffs of the strategies can be altered For example, the option based portfolio insurance strategy may be viewed as a

special case of the Constant-Proportion Portfolio Insurance in which parameters

change with levels of the cushion Further, the CPPI strategy can be transformed into a

constant mix strategy by constantly adjusting the floor to a specified percentage of the

asset values

Resetting of parameters can allow the portfolio allocator to make substantial changes in the exposures and payoffs of the strategy – potentially changing the entire character of the strategy as illustrated above by the ability to transform one strategy into another through constant parameter adjustment In particular, parameter resetting can be appropriate for horizon points or after major market movements

5 Describe examples of undiversified “strategies” that have allowed

individuals to become wealthy

Undiversified strategies that have worked for a minority of investors include:

1 using leverage in real estate by assuming a mortgage;

2 accumulation of low-basis stock and stock options and not diversifying; and

3 starting a small business

 In each case, there is the potential for large returns if the conditions are favorable, for e.g., a 20% down payment on a home provides a 50% return if the home increases in value by only 10% It should be noted that a large portion of those that have become wealthy have used these strategies, but this can be misleading, because there are many investors that used these strategies and did very poorly

6 Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth management and asset allocation

The primary change that has thrust more responsibility upon individuals is the movement from defined benefit to defined contribution plans This means that market risk has moved from the sponsoring firm to the individual The following factors have also increased the level of responsibility that individuals have for their own retirement:

1 estimating life expectancy and the general increase in life expectancy (with a defined benefit plan, the sponsor pays as long as the individual is alive);

2 achieving diversification from funds whose returns tend to have higher levels of correlation; and