CFA 2018 r26 alternative investments portfolio management slides

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

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:

5 Concentrated equity position of the client in a closely held company

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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

Real estate represents one-third to one-half of the world’s wealth!

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

Understand whether benchmark represents leveraged or unleveraged investments

Is the benchmark investable or not

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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

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Advantages of direct equity real estate investing

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Disadvantages of direct equity real estate investing

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

Across different regions

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Example 5

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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

• Private equity investments require distinct knowledge and

experience

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Exhibit 9

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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Exhibit 10

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

GP fee = percentage of LP commitments to fund + carried interest

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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Example 8

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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Example 9

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

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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

Major concepts:

• Different mechanisms of investing in commodities

• Role of commodities in portfolios

• Inflation hedging characteristics of different commodity classes

The Commodity Market

• Direct commodity investment

 Cash market purchase of physical commodities

 Commodity derivative contracts with direct

exposure to changes in spot prices

• Indirect commodity investment

 Equity in commodity-producing companies (issue:

does not provide effective exposure to changes in

segment.”

Benchmarks and Historical Performance

A variety of indexes based on futures prices can be used as benchmarks for the performance of

futures-based commodity investments

Major indexes: Reuters/Jefferies Commodity Research Bureau (RJ/CRB) Index, the S&P Goldman Sachs Commodity Index (GSCI), and the Bloomberg Commodity Index (BCOM)

Commodity indexes attempt to replicate returns comparable to long positions in futures contracts

Indexes differ in:

1 Composition

2 Weighting scheme (can not use market capitalization)

3 Return calculation (arithmetic vs geometric mean)

Most major indexes have sub-indexes based on commodity sector

Different versions based on how returns are calculated

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Commodity Index and Asset Class Performance, 1996 - 2015

Commodities: Investment Characteristics and Roles (1/2)

Low correlation with stocks and bonds but there are differences across commodity sectors

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Commodities behave differently under different economic conditions

• Business cycle-related supply and demand

• Convenience yield

• Real options under uncertainty

Commodities: Investment Characteristics and Roles (2/2)

Long-term growth in world demand for certain commodities in limited supply  source of return

Portfolio risk diversification

Inflation hedge

• Storable commodities which are directly linked with economic activity (Ex: crude oil)

• Some commodities, such as gold, serve as store of value during inflationary times

• Livestock and agriculture have shown negative correlation with unexpected inflation

Link between portfolio risk diversification and inflation hedging

Some researchers argue that inflation-hedging characteristics of commodities have disappeared

since the 2008-09 global financial crisis

Active strategies

Good inflation hedging

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

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Sections:

1 The Hedge Fund Market

2 Benchmarks and Historical Performance

3 Investment Characteristics and Roles

4 Performance Evaluation Concerns

The Hedge Fund Market

• Most hedge funds seek absolute return

• In theory there should be no need for a benchmark

• Some institutional investors ask for relative performance evaluation 

benchmarks needed

• Market size: US$200 billion in 1995 to US$2.8 trillion in 2014

• Number of hedge funds: 2,400 in 1995 to more than 10,000 in 2014

• Several hedge fund strategies have evolved over the last 15 years

Hedge Fund Strategies

• Equity market neutral

Fee Structure

Compensation structure: % of net asset value + incentive fee

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

High water mark and its rationale

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

Fund of Funds

1.5 plus 10 is a common fee structure, two layers of fees

Usually do not impose lock-out periods; FOF manager holds cash buffer

Benchmarks and Historical Performance

• Indexes which track hedge fund performance have evolved

 Some indexes track specific strategies

 Abnormal returns are most likely due to unmeasured risk

 CISDM, Credit Suisse Hedge Fund Index, HFR, Morningstar MSCI

• Distinguishing features of hedge fund indexes

 Report daily versus monthly

 Investable versus not investable

 List actual funds used in benchmark versus not listing actual funds

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Construction of Hedge Fund Indexes

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Hedge Fund Performance, 1996-2015

Performance of Hedge Fund Strategies and Traditional Assets, 1996–2015

CISDM EW

Hedge Funds

CISDM Equity Market Neutral

CISDM Convertible Arbitrage

CISDM Event Driven

CISDM Merger Arbitrage

CISDM Distressed Securities

CISDM Equity Long/ Short

CISDM Global Macro S&P 500

Bloomberg Barclays US Aggregate

Bloomberg Barclays US Corporate High Yield

Example 10: Liquid Alternatives

The term “liquid alternatives” (or liquid alts) refers to a variety of hedge fund–like investment strategies such as those offered in the United States through the Investment Company Act of 1940 fund structures (mutual funds, closed-end funds, and ETFs) Unlike hedge funds, liquid alternatives provide the daily liquidity and transparency characteristic of

“40 Act funds.” Liquid alts also typically have more attractive fee structures and are available to a wider range of

investors than corresponding hedge funds It is estimated that the liquid alt market consisted of 53 funds with $240 billion in assets under management at the end of 2014 Some of the strategies followed by liquid alts are outlined

below:

• Equity Long–Short This strategy typically selects stocks based on top-down or bottom-up fundamental analysis and hedges market exposure with short equity or long put exposure Liquid alts equity long–short strategies

correspond to hedge fund equity long–short strategies

• Event Driven This strategy takes equity or debt positions in firms involved in a corporate event such as a merger or restructuring Corresponding hedge fund strategies include merger arbitrage, distressed, and credit long–short

• Relative Value This strategy takes both long and short positions to benefit from relative mispricing between similar

or related securities Corresponding hedge fund strategies include convertible arbitrage and equity market neutral

• Macro Macro strategies are systematic or discretionary strategies that take long or short positions in a variety of asset classes (equities, bonds, currencies, commodities) based on macroeconomic conditions They often utilize trend-following or mean-reverting signals and correspond to global macro hedge fund strategies or managed

Interpretation Issues

• Biases in index creation

 Most databases are self-reported

 Value weighting versus equal weighting

 Investable versus non-investable indexes

• 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  inaccurate std dev and understated correlations

• Backfill bias (inclusion bias)

 Hedge funds with good past returns are more motivated to provide their data to indexes

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Example 11: Hedge Fund Benchmarks

CBA, a large charitable organization, is planning to make an investment in one or more hedge funds Alex Carr, CIO of CBA, is evaluating information prepared by the organization’s senior analyst, Kim

Park, CFA

Carr asks Park why a particular US-focused market-neutral long–short hedge fund CBA is considering has resisted accepting a US equity index as a benchmark

1 Prepare a response to Carr’s question to Park

2 Recommend an alternative to using a stock index benchmark for a market-neutral long–short

Hedge Funds: Investment Characteristics and Roles

Investment Characteristics

• Skill-based investment strategies  fund manager selection is extremely important

• Market opportunities vary across investment strategies and market conditions change

• Relatively low correlation with traditional investments

• Particular factors (return drivers) can explain returns of different strategies

 “Long-bias” equity strategies are influenced by changes in risk/return of underlying stocks

 Analysis of underlying factors in trading strategies is important

Roles in the Portfolio

• FOFs are popular entry-level investments

• Equally weighted portfolio of five to seven hedge funds  similar risk/return as population

• Diversification benefit but numbers need to be viewed with caution

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Including hedge funds in the portfolio can lead to:

• Lower skewness

• Higher kurtosis

Hedge Fund Performance in Portfolios, 2001–2015

Example 12: Skewness and Hedge Funds

In 2002, the S&P 500 dropped by more than 20% and distressed debt hedge funds as a group

achieved poor returns Equity market–neutral funds also achieved poor returns, a result that was

explained as relating to lower market liquidity

1 Explain why distressed debt hedge funds might have performed poorly in 2002

2 Explain how lower market liquidity might have negatively affected long–short market-neutral

hedge funds

Solution to 1: Major declines in equity markets lead to widening credit spreads and, all else being

equal, to capital losses on high-yield bonds Distressed debt hedge funds are exposed to the risk of

increased credit spreads; these considerations could explain why such funds fared poorly in 2002

Solution to 2: Maintaining market neutrality requires dynamic portfolio adjustments Declines in

market liquidity increase the cost of shorting equity markets

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Other Issues

• Performance and lock-up impacts

 Periods of severe drawdown may influence funds to dissolve

 Longer lock-up periods  higher returns

• Fund of funds

 Lower impact of survivorship bias relative to hedge fund indexes

 Style drift

• Effect of fund size

 Larger funds attract more talented people

 Smaller funds are more nimble

 On average large funds underperform small funds

• Age (vintage) effects

 Difficult to compare funds with track records over different periods/lengths

 Young funds outperform old funds on total return basis