R25 alternative investments portfolio management

Real Estate• This segment focuses on equity investments in real estate • Subsections:  The Real Estate Market  Benchmarks and Historical Performance  Real Estate: Investment Character

1 Introduction

2 Alternative Investments: Definitions, Similarities and Contrasts

Common Features of Alternative Investments

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 informationally less efficient

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Major investors in alternative investments:

High net worth individuals

Institutional investors (some might have restrictions)

Factors:

Illiquidity might be an issue for some investors; others

might benefit from illiquidity premium

Due diligence costs are often high

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1 Tax issues

2 Determining suitability

3 Communication with client

4 Decision risk: risk of changing strategies at point of maximum loss More likely when:

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3 Real Estate

• This segment focuses on equity investments in real estate

• Subsections:

 The Real Estate Market

 Benchmarks and Historical Performance

 Real Estate: Investment Characteristics and Roles

The Real Estate Market

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1 Direct ownership in residences, business real estate

and agricultural land

2 Companies engaged in real estate ownership,

development or management

3 Real estate investment trusts (REITs)

4 Commingled real estate funds (CREFs)

5 Separately managed accounts

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Benchmarks and Historical Performance

Many benchmarks are appraisal based

Appraisals are infrequent  volatility is understated

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Real Estate: Investment Characteristics and Roles

General Characteristics of real estate investment:

1 Lack of liquidity

2 Large lot sizes

3 High transaction costs

4 Heterogeneity

5 Immobility

6 Relatively low information transparency

Advantages of direct equity real estate investing

 Inflation hedge

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Disadvantages of direct equity real estate investing

Across different types of real estate: apartments, industrial, office, retail

Across different regions

…

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4 Private Equity/Venture Capital

• Ownership in a non-publicly-traded company

 Directly or through private equity fund

• Venture Capital vs Buyout Funds

• Private Investment in Public Company (PIPE)

 Example 5

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The Private Equity Market

• The need for venture capital

 Entrepreneurs might not have sufficient capital to grow company

 Entrepreneurs might want to diversify

 Entrepreneurs might seek expertise offered by VC firm

• Issuers of venture capital include

 Formative-stage companies

 Expansion-stage companies

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The Supply of Venture Capital

Buyout Funds

• Larger segment than VC funds

• Mega-cap buyout funds take public companies private

• Middle-cap buyout funds purchase private companies and add value by

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• Highly focused private governance model

• Realize value through

• Sale of acquired company

• Dividend recapitalization

• IPO

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Direct VC investment is structured as convertible preferred stock rather than

common stock; corporation must pay cash equal to some multiple of original

investment before cash can be paid to common shareholders

Indirect investment is through private equity funds

Structured as limited partnership or LLC  avoids double taxation inherent in

corporate form

Benchmarks and Historical Performance

• Events that indicate market value occur infrequently  stale prices

• Low correlation with publicly traded securities

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Interpretation Issues:

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Private Equity: Investment Characteristics and Roles

• For both VC and Buyout

 Illiquidity

 Long term commitment required

 Higher risk than seasoned public equity investment

 High expected IRR required

• For VC

 Limited information

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VC funds and buyout funds have some expected differences in return

characteristics

1 Buyout funds are usually highly leveraged

2 The cash flows to buyout fund investors come earlier and are often steadier

than those to VC fund investors

3 The returns to VC fund investors are subject to greater error in measurement

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Moderate risk diversification is consideration but major objective is typically long term

return enhancement

Issues in formulating strategy:

1 Ability to achieve sufficient diversification

2 Liquidity of the position

3 Provision for capital commitment

4 Appropriate diversification strategy

Framework discussed in Example 2 applies; each due diligence item falls in one of:

1) Evaluation of prospected for market success

2) Operational review

3) Financial/Legal review

In selecting funds consider the following:

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5 Commodity Investments

Subsections:

• The Commodity Market

• Benchmarks and Historical Performance

Commodities: Investment Characteristics and Roles

Homogenous, tangible assets  futures contracts

Commodity trading advisors (CTAs) are registered advisors to

managed futures funds

The Commodity Market

• Direct commodity investment

 Cash market purchase of physical commodities

• Indirect commodity investment

 Equity in commodity-producing companies (issue: does not provide

effective exposure to changes in commodity prices)

 Exposure through derivative products

 Investible commodity indices

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Benchmarks and Historical Performance

Commodity indices attempt to replicate returns comparable to long positions in

futures contracts

Major indices contain different groups of underlying assets

Indices differ widely in:

1 Composition

2 Weighting Scheme (can not use market capitalization)

3 Arithmetic vs Geometric Mean for Return Calculation

Low Sharpe ratio

Low correlation with traditional asset classes

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Commodity Index Return Components

1 Spot Return or Price Return

2 Collateral Return

3 Roll Return

Roll return arises from rolling long futures positions forward through time

Price

Maturity

Given that spot price does change…

roll return is = change in futures contract price – change in spot price

Backwardation means futures price < spot price  roll return positive

Contango means futures price > spot price  roll return negative

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You establish a long position in the June 200X contract in April 200X when the futures price is 39.10 One month later the futures price is 40.58 What is the roll return?

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Commodities: Investment Characteristics and Roles

• Low correlation with stocks and bonds

 During financial and economic distress commodity prices tend to rise

• Determinants of commodity returns

 Business cycle-related supply and demand

 Convenience yield

 Real options under uncertainty

Commodities included in portfolios because they are:

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Long-term investors with liabilities indexed to inflation, such as defined benefit plans, may

be able to improve their risk adjusted return tradeoff by including commodities in portfolios

6 Hedge Funds

• First hedge fund establish in 1940 as a long-short fund

• “Hedge Fund” is now a much broader term

• Loosely regulated pooled investment vehicles

• Take advantage of market opportunities

• Hedge funds have grown in popularity (1990 AUM = $50 billion,

2005 AUM = $1 trillion, over 8000 hedge funds)

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The Hedge Fund Market

• Most hedge funds seek absolute return (Example 10)

• In theory there should be no need for a benchmark

• Some institutional investors ask for relative performance

evaluation  benchmarks needed

Several hedge fund strategies have evolved over the last 15 years

Hedge Fund Strategies

expectations

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Hedge Fund Strategies (Cont…)

market neutral (highest AUM of all strategies)

non-financial markets through trading in currencies, futures and option

contracts

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Fee Structure

Compensation structure: % of net asset value + incentive fee

Example: 1 plus 20 fund would earn 4% if there is a 15% gain

AUM fee

High water mark

Lock up period: one to three years, after that redeem within specified exit windows

Fund of Funds

Benchmarks and Historical Performance

• Distinguishing features of hedge fund indices

 Investable, or not

 List actual funds used in benchmark, or not

• Construction of hedge fund indices

HFCI is the CISDM’s Hedge Fund Composite Index

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Interpretation Issues

• Biases in index creation

 Most databases are self-reported

• Relevance of past data on performance

 Past data might reflect performance of previous managers

 Volatility of returns is more persistent than actual returns

• Survivorship bias

 Managers with poor records exit business; removed from database

• Stale price bias

 Lack of security trading  stale prices  correlations understated

• Backfill bias

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Hedge Funds: Investment Characteristics and Roles

• Skill-based investment strategies  fund manager selection is

extremely important

• Relatively low correlation with traditional investments

• Particular factors can explain returns of different strategies

( Exhibit 25 )

• Equally weighted portfolio of five to seven hedge funds has

similar standard deviation as population

Other Issues

• Research seems to indicate

 Young funds outperform old funds on total return basis

 On average large funds underperform small funds

 FOFs may provide closer approximation to return estimation than

indices; less direct impact of survivorship bias; classification and style

drift can be an issue

• Above factors should be analyzed carefully before making a

decision

• Periods of severe drawdown may influence funds to dissolve

(especially if there is a HWM provision)

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Hedge Fund Due Diligence

In addition to Example 2 framework also consider:

• Structure of hedge fund

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Performance Evaluation Concerns

When reviewing the performance of a hedge fund we should consider:

Returns

HPR is then annualized

Compounding frequency can impact apparent performance

“Look through” leverage as if asset were fully paid

Rolling return is the moving average

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7 Managed Futures

• Structured as limited partnerships open to accredited investors

• Invest in cash, spot and derivative markets; can use leverage

• Compensation arrangement similar to hedge funds

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Managed Futures Hedge Funds

Focused on derivative markets (forwards,

futures and options)

Primarily trade market based futures and

options contracts on broader or more

generic basket of assets

Look for return opportunities in macro

(index) stock and bond markets

Active in spot markets withderivatives used for hedgingTrade in individual securities

Exploit inefficiencies in micro stockand bond markets

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Managed Futures Market

Benchmarks and Historical Performance

Interpretation Issues: Be aware of survivorship bias

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Investment Characteristics and Roles

• Derivatives are a zero-sum game; hence for CTAs to earn a return above the

risk free rate there must be enough hedgers who will accept a return less

than the risk free rate

• Arbitrage when the opportunity exists

• Most actively managed derivative strategies follow momentum strategies

• Easy to take short position; hence can earn positive excess return in falling

markets

• A randomly selected equally weighted portfolio of 8-10 CTAs has a standard

deviation similar to the population from which it is drawn

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8 Distressed Securities

• Securities of companies that are in financial distress or near

bankruptcy

• Securities could be equity or debt

• Investment strategies exploit fact that…

 many investors are unable to hold below investment grade securities

 few analysts cover distressed securities

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Distressed securities managers can trade in many types of assets…

Benchmarks and Historical Performance

• In the context of hedge funds, distressed securities investing is often

classified as a sub-style of event-driven strategies

• All major hedge fund indices have a sub-index for distressed securities

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Risk measured by standard deviation is probably understated

Investment Characteristics and Roles

• Risks not well captured by standard measures like correlation

and standard deviation

• Main driver is generally high returns

• Different investment strategies

 Long-only value investing

 Distressed debt arbitrage: purchase bond and short equity

 Private equity: involves corporate activism

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Major Risks

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Solution to 1

Solution to 2

• Covered 6 types of alternative investments: Real Estate, Private

Equity, Commodity Investments, Hedge Funds, Managed Futures, Distressed Securities

• For each type understand:

 What it means and the market

 Benchmarks, along with limitations

 Investment characteristics

 Role in a portfolio (includes understanding the risks)

 Due diligence

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