CFA 2018 level 1 fintree introduction to alternative investments ebook 10

Introduction to Alternative Investments LOS a LOS b Comparison of alternative investments with traditional investments Categories of alternative investments ª Less liquid ª More speciali

TM JuiceNotes

eBook 10

CFA Level 1 JuiceNotes 2017

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Alternative Investments

Introduction to Alternative Investments LOS a

LOS b

Comparison of alternative investments with traditional investments

Categories of alternative investments

ª Less liquid

ª More specialized by managers

ª Less regulated and transparent

ª More problematic and have less available historical data

ª Different legal issues and tax treatments

It is a Mutual Fund like structure for High Net worth Individuals (HNIs) These funds use leverage, hold long and short positions, use derivatives and invest in illiquid assets

Includes investment in tangible collectibles such as stamps, antique furniture, art, fine wines as well as intangibles such as patents

Hedge funds

Other

Compared to traditional investments,

alternative investments are

1

6

Invest in

companies at

their early

stages in life

Full or leveraged ownership

Buying

gold/silver

coins or bars,

grains etc.

Buying/short selling futures of copper, entering into

a forward contract for potato etc.

Use borrowed money to purchase equity

in established companies Most prevalent

Real estate backed loans, securities backed by pools

of properties or mortgages and limited partnerships

Investing in the equity of commodity producing firms Problematic if the company itself hedges the exposure

Roads, airports, utility grids etc.

Schools, hospitals etc.

Venture

capital

funds

Residential properties

Physical

commodities

Economic infrastructure

Social infrastructure

Commercial properties

Commodities derivatives

Real estate backed debt

Equity

Leveraged buyout funds

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Potential benefits of alternative investments

in the context of portfolio management LOS c

LOS d

Alternative investments have had low correlations with traditional investments which provides benefits of diversification

Historically alternative investments have had higher returns on average than traditional investments, so adding alternative investments to a

traditional portfolio may increase expected returns

Adding alternative investments to a portfolio reduces portfolio risk and increases expected return, however there are problems with

historical data and traditional risk measures

Lockup period

Notice period

Fund of funds

Survivorship bias refers to the upward bias of returns if data is included only for currently existing (surviving) firms

Backfill bias refers to upward bias introduced by including the previous performance data for firms recently added to a benchmark index

The reasons for these higher returns are thought to be that

ª Alternative investments are less efficiently priced than traditional investments, providing opportunities for skilled managers

ª Alternative investments may offer extra returns for being illiquid

ª Alternative investments often use leverage

Hedge funds

1

Time after initial investment during which withdrawals are not allowed The amount of time a fund has to fulfill the redemption request after receiving the request

An investment company that invests in hedge funds

Advantages

Disadvantage

Ÿ Gives investors diversification among hedge fund strategies

Ÿ Helps smaller investors to invest in hedge funds

Ÿ They charge an additional layer of management fees

ª Pools of investor funds that are not as regulated as mutual funds

ª Limited in the number of investors

ª Often sold only to qualified investors

ª Minimum investments is quite high ($250k to $1m)

ª Use leverage, hold long and short positions, use derivatives and invest in illiquid assets

ª Typically use prime brokers who provide multiple services such

as custodial, administrative, money lending, securities lending and trading

ª Investors are limited partners and managers are general partners

ª Hedge fund return objectives can be absolute (20%) or relative (Benchmark + 5%)

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Hedge fund strategies

Distressed/

restructuring

Asset-backed fixed income

Activist shareholder

Special situations

Volatility Multi-strategy

Merger

arbitrage

Convertible

arbitrage fixed

income

Buy shares of the

firm being acquired

Sell short shares of

the acquirer

Exploit pricing

discrepancies

between

convertible

bonds

common stock

of the issuing

company

Buy shares of firms

in financial distress Short overvalued securities

Exploit pricing discrepancies among various MBS or ABS

Buy sufficient equity shares to influence a company’s policies with the goal of increasing company value

General fixed income

Exploit pricing discrepancies between fixed income securities of various types

Invest in securities of firms that are issuing/repurchasing securities, spinning off divisions, selling assets, or distributing

capital

Exploit pricing discrepancies arising from differences between returns volatility implied

by options prices and manager expectations of future volatility

If Implied volatility >

Expected volatility

= Overvalued

Exploit pricing discrepancies among securities

in asset classes different from those previously listed and across asset classes and markets

Event-driven

Relative value

Macro strategies

These strategies are based on a corporate restructuring or acquisition that creates profit opportunities for long or short positions in securities of a specific corporation

These strategies involve buying a security and selling short a related security with the goal of profiting when one thinks there is a pricing discrepancy between the two

These are based on global economic trends and events and may involve long or short positions in equities, fixed income, currencies or commodities

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Fundamental growth

Fundamental value

Quantitative directional Short bias

Market

neutral

Use technical/

fundamental

analysis to

short overvalued

shares and buy

undervalued

shares in

approximately

equal amounts to

profit from their

relative price

movements

without exposure

to market risk

Use fundamental analysis to find high growth companies

Identify and buy shares of companies that are expected to sustain relatively high rates of capital appreciation

Buy undervalued shares based on fundamental analysis It is the hedge fund structure

Buy undervalued shares and short overvalued shares based on technical analysis

Mostly use short positions in overvalued shares, with smaller long positions, but with negative market exposure overall

Equity hedge fund

Leveraged buyout funds

Venture capital funds

Distressed investment funds

Developmental capital funds

Private equity

2

Management

buyouts

Management

buyins

External management team replaces existing team

Existing management team is involved

in the purchase

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Venture capital funds Ÿ Investment is often in the form of equity but can be in convertible

preferred shares or convertible debt

Ÿ The companies in which a venture capital fund is invested are referred to as its portfolio companies

Ÿ Venture capital fund managers often sit on their boards or fill key management roles of portfolio companies

Various stages at which venture capital investment is made

Formative stage

Later stage

Mezzanine-stage

financing

Angel investing

Seed stage

Early stage

ª Investments made during firm’s earliest period

ª comprised of three phases

ª Funds provided at this stage are typically used for expansion of production and/or increasing sales though an expanded marketing campaign

ª Capital provided to prepare the firm for an IPO

Ÿ Investments made very early (“idea” stage)

Ÿ funds are used for business plans and assessing market potential

Ÿ funding source is usually individuals (“angels”) rather than venture capital funds

Ÿ Investments made for product development, marketing and market research

Ÿ This is the stage where VC funds make initial investments, through ordinary or convertible preferred shares

Ÿ Investments made to fund initial commercial production and sales

Mezzanine financing means debt or preferred stock that are subordinate to the high-yield bonds and carry warrants or conversion features that give investors participation in equity when value increases

Developmental capital Distressed investing

Ÿ Known as minority equity investing

Ÿ Refers to the provision of capital for

business growth or restructuring

Ÿ When public companies are

financed with such funds, it is referred to as private investment in public equities (PIPEs)

Ÿ It refers to buying debt of mature companies that are experiencing financial difficulties

Ÿ Investors in distressed debt take active role in working with management on reorganizing or determining the direction the company should take

Ÿ They are sometimes referred to as

vulture investors

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ª They are typically structured as limited partnerships

ª Committed capital is the amount of capital provided to the fund by investors

ª It is typically not invested all at once but is “drawn down” (invested) as

securities are identified and added to the portfolio

Private equity exit strategies

Potential benefits and risks of private equity

ª Drawdown period - Typically 3 - 5 years

ª Management fees - Typically 1% - 3%

ª Clawback provision - It requires the manager to return any periodic incentive fees to investors if investors receive less than 80% of the profits generated by

portfolio investments as a whole

Ÿ Trade sale - Sell a portfolio company to a competitor or another strategic buyer

Ÿ IPO - Sell all or some shares of the company to the public

Ÿ Recapitalization - Company issues debt to fund a dividend distribution to equity holders (the fund) This is not an exit , but is often a step toward an exit

Ÿ Secondary sale - Sell a portfolio company to another private equity firm or a

group of investors Most prferred strategy

Ÿ Write-off/liquidation - Reassess and bear the losses from an unsuccessful outcome

ª Private equity has less than one correlation with traditional investments Therefore

there may be benefits of diversification from including private equity in portfolios

ª Standard deviation of private equity returns has been higher than the standard

deviation of equity index returns, which suggests greater risk

ª Choosing skilled fund managers is important

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Real estate

3

Residential property

Commercial property Mortgages

Single-family homes

Direct investment in real

estate Can be cash investment

or leveraged investment

(property purchased with

a mortgage) Lenders often sell their

mortgages They are later

securitized and traded as

Mortgage Backed Securities (MBS)

These properties generate income from rents Long time horizons, illiquidity, Large size of investment and their complexity make commercial properties inappropriate for many

investors

These are also considered

a direct investment in real

estate Loans can be pooled into Commercial Mortgage Backed Securities (CMBS) that represent an indirect

investment

Produces

Other real estate assets

Real Estate Investment Trusts (REITs) ª They issue shares that trade publicly like shares of stock

(liquid)

ª They can hold mortgages, hotel properties, malls, office buildings, or other commercial property

ª Income is used to pay dividends (tax exempt)

Timberland Farmland

Returns come from sales of

timber Returns also include price changes on timberland

Returns come from sales of agricultural products Returns are also based on land price changes, changes in farm commodity prices, and the quality and quantity of the crops produced https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd.

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Potential benefits and risks of real estate

ª Real estate performance is measured by three indices

ª Appraisal index - It is based on periodic estimates of property values

ª Appraisal index returns have lowest standard deviation of other index methods

ª Repeat sales index - It is based on price changes for properties that have sold multiple times

ª REIT indices - are based on the actual trading prices of REIT shares

ª REIT index returns and global equity returns have strong correlation (business cycles affect

REITs and global equities similarly)

ª REIT index returns and global bond returns have low correlation

Commodities

4

Equities directly linked

to commodity

Specialized funds in specific sectors

Individual managed accounts

Managed futures funds

Commodity

ETFs

Suitable for

investors who are

limited to buying

equity shares

They invest in

commodities or

commodity

futures

Investment in shares of commodity producing firm Drawback - Price movement of the stock may not be perfectly correlated with price movements

of the commodity

Actively managed Some managers concentrate on specific sectors while others are more diversified They can be structured as limited partnerships or mutual funds

It is an alternative to pooled funds for HNIs Accounts are tailored to the needs of investors

Can be organized under any of the structures Focus on specific commodities

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Potential benefits and risks of commodities

Commodity prices and investments

ª Returns on commodities < returns on stocks/bonds

ª Sharpe ratio for commodities is low because of lower returns and

high standard deviation

ª Commodity prices tend to move with inflation rates, therefore holding commodities can act as a hedge against inflation

ª Spot prices for commodities are a function of supply and demand

ª Global economics, production costs and storage costs, along with

value to user, all factor into prices

Transportation

assets

Roads, airports,

ports and

railways etc.

Electric generation and distribution, waste disposal

etc.

Broadcast assets and cable systems etc.

Prisons, schools, health care facilities etc.

Utility assets Communications

Various types of tangible collectibles such as rare wines, art, rare coins and stamps, valuable jewelry and watches, and sports memorabilia

are considered investments

Social

Infrastructure

Other alternative investments

5

Investments in infrastructure assets that are already constructed Provides stable cash flows and relatively high yields, but offers little potential for growth

Involves uncertainty and may provide relatively lower yields, but offers greater growth potential

Investments in infrastructure assets that are to be constructed

Brownfield investments

Greenfield investments

-Management and incentive fees LOS e

Most common fee structure for a hedge fund

2% = Management fee 20% = Incentive fee

2 and 20 (2/20)

Management fee is paid irrespective of investment performance

Incentive fee is paid as a percentage of profits

Old

New

Hurdle rates

Eg #1

Eg #2

Opening value = 100 Closing value = 140 Hurdle rate = 12% Incentive fee = 20%

Hedge fund opening value = $150 mln Fee structure = 2/20 Hard hurdle rate = 5%

Ending value (Year 1) = $175 mln Ending value (Year 2) = $180 mln

Incentive fees are calculated net of management fees Calculate total fees and investor’s net return

Opening value = 100 Closing value = 140

Profit = 40

Hard hurdle rate Soft hurdle rate

40 40

-12

40 28

8 5.6

Profit Profit

Soft hurdle Hard hurdle

Management fees = $150 mln × 2% = $3 mln Management fees = $169.1 mln × 2% = $3.382 mln

Incentive fees

= [$175 mln − $150 mln − 3 − ($150

mln × 5%)] × 20% = $2.9 mln

Incentive fees

= [$180 mln − $169.1 mln − 3.382 − ($169.1 mln × 5%)] × 20% = $0

Total fees = $3 mln + $2.9 mln = $5.9 mln Total fees = $3.382 mln

Ending value net of fees

= $175 mln − $5.9 mln = $169.1 mln

Ending value net of fees

= $180 mln − $3.382 mln = $176.618 mln

Investor’s net return

= ($168.9 mln/$150 mln) − 1 = 12.73%

Investor’s net return

= ($176.618 mln/$169.1 mln) − 1 = 4.44%

Incentive fee (20%)

Incentive fee (20%)

In year 2, incentive fee = 0 because return did not exceed hurdle rate

High water mark

t = 100 0

t = 130 1

t = 150 3

Incentive fee = 150 - 130

= 20 x 20% = 4

t = 80

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