CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r26 alternative investments portfolio management IFT notes

LO.d: Distinguish among types of alternative investments LO.e: Discuss the construction and interpretation of benchmarks and the problem of benchmark bias in alternative investment group

Alternative Investments Portfolio Management

1 Introduction 3

2 Alternative Investments: Definitions, Similarities, and Contrasts 3

3 Real Estate 5

3.1 The Real Estate Market 5

3.2 Benchmarks and Historical Performance 5

3.3 Real Estate: Investment Characteristics and Roles 6

4 Private Equity/Venture Capital 7

4.1 The Private Equity Market 8

4.2 Benchmarks and Historical Performance 11

4.3 Private Equity: Investment Characteristics and Roles 11

5 Commodity Investments 12

5.1 The Commodity Market 12

5.2 Benchmarks and Historical Performance 13

5.3 Commodities: Investment Characteristics and Roles 14

6 Hedge Funds 15

6.1 The Hedge Fund Market 15

6.2 Benchmarks and Historical Performance 16

6.3 Hedge Funds: Investment Characteristics and Roles 19

6.4 Performance Evaluation Concerns 20

7 Managed Futures 22

7.1 The Managed Futures Market 23

7.2 Benchmarks and Historical Performance 23

7.3 Managed Futures: Investment Characteristics and Roles 24

8 Distressed Securities 25

8.1 The Distressed Securities Market 25

8.2 Benchmarks and Historical Performance 25

8.3 Distressed Securities: Investment Characteristics and Roles 26

Summary 27

Examples from the Curriculum 34

Example 1 Alternative Investments in a Low-Return Environment 34

Example 2 How One University Endowment Evaluates Alternative Investments 35

Example 3 Alternative Investments and Core–Satellite Investing 36

Example 4 Timberland and Farmland 36

Example 5 Adding Real Estate to the Strategic Asset Allocation 36

Example 6 Private Investment in Public Entity (PIPE) 38

Example 7 The IPO of Google 38

Example 8 A Nonmarketable Minority Interest 39

Example 9 An Investment in Private Equity 39

Example 10 Liquid Alternatives 41

Example 11 Hedge Fund Benchmarks 41

Example 12 Skewness and Hedge Funds 42

Example 13 An Investor Does Due Diligence on a Hedge Fund 43

Example 14 Adding Managed Futures to the Strategic Asset Allocation 44

Example 15 Turnaround Partners 45

Example 16 Distressed Securities Investing 45

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®

Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

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

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trademarks owned by CFA Institute

2 Alternative Investments: Definitions, Similarities, and Contrasts

LO.a: Describe common features of alternative investments and their markets and how alternative

investments may be grouped by the role they typically play in a portfolio

Some of the common features of alternative investments are:

 They are generally illiquid, because of which investors demand an illiquidity premium

 When added to a portfolio of stocks and bonds, they provide diversification potential

 They have high due diligence costs (Example: Compared to a Fortune 500 company stock a lot

more due diligence needs to be done when you are investing in real estate)

 Performance appraisals are difficult because establishing valid benchmarks is a complex process

As compared to stock and bond markets, the alternative investment markets are informationally less

efficient Refer to Exhibit 1 from the curriculum, which gives us a sense of the investment universe

including both traditional investments and alternative investments Alternative investments can be

classified into traditional or modern as shown below

Apart from the above classification, alternative investments can also be classified according to the role

they play in an investor’s portfolio

 Investments that provide exposure to risk factors that are not easily accessible through

traditional stock and bond investments For example, real estate and commodities

 Investments that provide exposure to specialized investment strategies run by an outside

manager For example, hedge funds and managed futures These investments are heavily

dependent on the skills of the manger

 Investments that are a combination of the above two groups For example, private equity funds

and distressed securities

Refer to Example 1 from the curriculum

The major investors in alternative investments are:

 High net worth individuals

 Institutional investors However, some restrictions may apply and they may be able to invest in

only certain kinds of alternative investments

The factors that we need to consider when we invest in alternative investments are:

 Liquidity: Alternative investments are generally illiquid and this can be an issue for some

investors However, if the investor has a long term horizon, then the extra premium associated

with the illiquidity can be good for the investor

 The due diligence costs are often high For a small investor due diligence costs can represent a

high percentage of the investment and investing in alternative investments would not make

sense

LO.b: Explain and justify the major due diligence checkpoints involved in selecting active managers

of alternative investments

Refer to Example 2 from the curriculum

LO.c: Explain distinctive issues that alternative investments raise for investment advisers of private

wealth clients

Example 2 provides a set of items applicable to institutional investors Advisors to high net worth

individuals should consider the following additional factors

1 Tax issues: You need to understand the tax implications of various investments

2 Determining suitability: The alternative investment must align with the risk/return objective in

the IPS

3 Communication with client: You need to explain complex investment strategies to someone who

potentially does not know much about the investment process

4 Decision risk: This is the risk of changing strategies at the point of maximum loss

5 Concentrated equity position of the client in a closely held company: Some clients may have a

substantial part of their wealth in a closely held company, this should be considered

Refer to Example 3 from the curriculum

LO.d: Distinguish among types of alternative investments

LO.e: Discuss the construction and interpretation of benchmarks and the problem of benchmark

bias in alternative investment groups

LO.f: Evaluate the return enhancement and/or risk diversification effects of adding an alternative

investment to a reference portfolio (for example, a portfolio invested solely in common equity and

bonds);

Note: LO.d, LO.e and LO.f are covered in sections 3 – 8

3 Real Estate

3.1 The Real Estate Market

Real estate represents one-third to one-half of the world’s wealth Both individual and institutional

investors invest in real estate

The various ways in which investors participate in real estate are:

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) – They are publicly traded equities representing

investments in real estate Investors get cash from underlying real estate

4 Commingled real estate funds (CREFs) – They represent a pooled investment in real estate The

two types are: open-end and closed-end funds The advantage of this option is that it provides

access to the expertise of professional managers

5 Separately managed accounts – They are typically offered by same real estate advisors

sponsoring CREFs

6 Infrastructure funds – This includes a consortium of private companies that build projects for

public use and receive revenue stream over a contracted period

3.2 Benchmarks and Historical Performance

The key issues when using a benchmark to measure real estate performance are:

 Performance of private equity in real estate may vary and does not necessarily correlate with

the benchmarks

 Also it has been observed that the real estate market lags behind publicly traded real estate

securities

The key points to consider about a real estate benchmark are:

 Many benchmarks are appraisal based Since the appraisals are infrequent, the volatility is

understated

 You need to consider whether the benchmark represents leveraged or unleveraged

investments Generally leveraged benchmarks tend to have higher volatility and higher returns

 You need to consider whether the benchmark is investable or not Investable means that the

underlying assets can be bought

Exhibit 2 provides a list of selected real estate benchmarks

Begin Date Frequency

Australia Property Council of Australia

index (PCA)

Canada Institute of Canadian Real Estate

Investment Managers

(ICREIM)/IPD Canadian Property

Index

France Investment Property Databank

(IPD)

and monthly United

Kingdom

and monthly United

Property Performance (MIT

Center for Real Estate)

Individual properties; based

on transaction prices of properties sold from the NCREIF Index database

1984 Quarterly

Wilshire real estate indices REITs and real estate

operating companies

1978 Daily

World FTSE EPRA/NAREIT Global Real

Estate Index

Refer to Example 4 from the curriculum

3.3 Real Estate: Investment Characteristics and Roles

The general characteristics of real estate investments are:

1 Lack of liquidity – Property are not frequently traded

2 Large lot sizes – You need to spend a fair amount of money to invest in real estate

3 High transaction costs – Real estate brokers tend to charge a lot

4 Heterogeneity – Every property is different

5 Immobility – You cannot move a house

6 Relatively low information transparency – For example, there might be structural defects in a

building that may be hard to detect

LO.g: Describe advantages and disadvantages of direct equity investments in real estate

The advantages of direct equity real estate investing are:

 Most expenses related to real estate like interest payments, property taxes are tax deductible

 As compared to other securities, a higher financial leverage can be used in real estate by taking

out a mortgage loan

 Investors have direct control over the property and can take steps to increase its value

 The value of real estate investments in different locations have low correlations, hence

geographical diversification can be used to reduce risk

 Real estate returns have low volatility when compared to public equities They provide a good

hedge against inflation

The disadvantages of direct equity real estate investing are:

 Most real estate cannot be divided into smaller pieces, hence they can form a large part of an

investor’s total portfolio and increase his risk

 There is usually a high cost to acquire information about a piece of real estate

 Compared to other securities, the transaction costs are high

 Considerable operating and maintenance costs and management expertise is required when

investing in real estate

 Property owners are exposed to conditions beyond their control, for example neighborhood

deterioration

 Current tax benefits may be discontinued by the government in future

Roles in the portfolio

Real estate markets usually follow economic cycles Good forecasting of the economic cycles can allow

an investor to increase his returns from the real estate market

The role of real estate as a diversifier

Real estate provides some diversification benefit when added to a portfolio consisting of stocks and

bonds

Diversification within real estate itself

An investor can achieve diversification within real estate itself, by investing across different types of real

estate (apartments, industrial, office, retail etc.) or by investing across different geographic regions

Refer to Example 5 from the curriculum

4 Private Equity/Venture Capital

Private equity represents ownership in a non-publicly traded company The investment can either be a

direct investment or through a private equity fund

Private equity funds are pooled investment vehicles through which many investors make investments in

non-publicly traded companies The two main types of private equity funds are:

 Venture capital: They invest in relatively new companies, with an intention of growing them

 Buyout funds: They buy well established companies with an intention of making them more

efficient Private Investment in Public Entity (PIPE) refers to taking a publicly owned company

private

Refer to Example 6 from the curriculum

Exhibit 9 summarizes the main differences between private equity investments and publicly traded

securities

Private Equity Investments Publicly Traded Securities

Structure and Valuation

Deal structure and price are negotiated between

the investor and company management

Price is set in the context of the market Deal structure is standardized Variations typically require approval from securities regulators

Access to Information for Investment Selection

Investor can request access to all information,

including internal projections

Analysts can use only publicly available information to assess investment potential

Post-Investment Activity

Investors typically remain heavily involved in the

company after the transaction by participating at

the board level and through regular contact with

management

Investors typically do not sit on corporate boards

or make ongoing assessments based on publicly available information and have limited access to management

Source: Prepared by Andrew Abouchar, CFA, of Tech Capital Partners

4.1 The Private Equity Market

LO.h: Discuss the major issuers and suppliers of venture capital, the stages through which private

companies pass (seed stage through exit), the characteristic sources of financing at each stage, and

the purpose of such financing

Venture capital is required because:

 Entrepreneurs might not have sufficient capital to grow company

 Entrepreneurs might want to diversify

 Entrepreneurs might seek expertise offered by a venture capital (VC) firm

Issuers of venture capital include:

 Formative stage companies: This includes newly formed companies

 Expansion-stage companies: This includes young companies that need capital to expand

The various financing stages through which many private companies pass include the following:

Early-Stage Financing

 Seed – Seed money is relatively small amount of money provided to prove that an idea has a

reasonable chance of commercial success

 Start-up – At this stage the idea has been proven, but the company needs capital to bring the

idea to commercialization

 First stage – If the company has used up funds provided in the seed and start-up stage it may

seek additional funds

Later-Stage Financing

This includes financing to companies that are doing well and need funds to expand sales

The Exit

The possible exit strategies are:

 Merger with another company

 Acquisition by another company

 An IPO by which the company becomes publicly traded

Exhibit 10 shows the venture capital timeline

Formative-Stage Companies Expansion-Stage Companies

Seed Start-Up First Stage

Second Stage

Third Stage Mezzanine

Stage

characteristics

Idea incorporation, first personnel hired, prototype development

Moving into operation, initial revenues

Revenue growth Preparation for

Angels, venture capital Venture capital, strategic

partners

Purpose of

financing

Supports market research and establishment of business

Start-up financing supports

product development and initial marketing

First-stage financing supports such

activities as initial manufacturing and sales

Second-stage financing supports the initial

expansion of a company already producing and selling a product

Third-stage financing provides capital for

major expansion

Mezzanine (bridge) financing provides

capital to prepare for the IPO—often a mix of debt and equity

a

FF&F = founder’s friends and family The sources of financing are listed in typical order of importance

The supply of venture capital

Suppliers of venture capital include:

 Angel investors: An accredited individual investing chiefly in seed and early-stage companies

 Venture capital: (VC) refers broadly to the pools of capital managed by specialists known as

venture capitalists who seek to identify companies that have great business opportunities but

need financial, managerial, and strategic support

 Large companies: Some large companies invest in promising young companies in the same or

related industry This is called corporate venturing

Refer to Example 6 from the curriculum

Buyout Funds

Buyout funds are a larger segment than VC funds The two major groups are:

 Mega-cap buyout funds that take public companies private

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

o Restructuring operations and improving management

o Opportunistically identifying and executing the purchase of companies at a discount to

intrinsic value

o Capturing any gains from the addition of debt or restructuring of existing debt

They have a highly focused private governance model They realize value through

 Sale of acquired company

 Dividend recapitalization: This involves the issuance of debt to finance a special dividend to

owners

 IPO

LO.k: Explain the typical structure of a private equity fund, including the compensation to the fund’s

sponsor (general partner) and typical timelines

Types of Private Equity Investment

LO.j: Discuss the use of convertible preferred stock in direct venture capital investment

Direct VC investment is structured as convertible preferred stock rather than common stock Hence, the

corporation must pay the preferred stockholders cash equal to some multiple (e.g., 2x) of the original

investment before cash can be paid to common shareholders If there is a buyout of the company that is

favourable to the shareholders then the preferred stock will be converted to common stock

Indirect VC investment is through private equity funds The funds are usually structured as limited

partnerships or LLC, to avoid double taxation inherent in a corporate form

The fee of the fund manager usually consists of a management fee plus an incentive fee The incentive

fee is called carried interest and is usually expressed as a percentage of the total profits of the fund

Most funds come with a claw-back provision which specifies that some money from the fund manager

be returned to investors if at the end of a fund’s life investors have not received back their capital

contributions and contractual share of profits

Time line: At the beginning of the fund the sponsor gets commitments from the investors and then gives

‘capital calls’ typically over the first five years This is called commitment period The expected life of the

fund is seven to ten years There is often an option to extend the life up to five more years

4.2 Benchmarks and Historical Performance

Events that indicate the market value of a private equity investment occur infrequently This leads to

stale prices and is a major challenge for index construction

Historically it has been seen that private equity funds have a low correlation with publicly traded

securities

The main interpretation issues associated with private equity are:

 Most private equity investors calculate returns in terms of IRR based on values estimated by the

fund manager’s appraisals and not market values Appraised values are stale and there is no

generally accepted standard for appraisals

 The life cycle stage of a fund and the economic conditions prevalent at the time a fund started

influence its returns These effects are known as “vintage year effects” Investors often compare

funds with the same vintage year

4.3 Private Equity: Investment Characteristics and Roles

Investment Characteristics

The general investment characteristics for both VC and buyout are:

 Illiquidity

 Long term commitment required

 Higher risk than seasoned public equity investment

 High expected IRR required

Additionally for VC, the following is also applicable

 Limited information: For new ventures, cash flow projections are often based on limited

information and need many assumptions

Refer to Example 8 from the curriculum

LO.i: Compare venture capital funds and buyout funds

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

Refer to Example 9 from the curriculum

Roles in the Portfolio

LO.l: Discuss issues that must be addressed in formulating a private equity investment strategy

Moderate risk diversification is achieved by adding private equity to a portfolio However the major

objective for private equity investments is typically long term return enhancement

The major issues in formulating a strategy for private equity investments are:

1 Ability to achieve sufficient diversification: As investments in private equity are large a

substantial portfolio size is required to achieve sufficient diversification

2 Liquidity of the position: Investments are generally illiquid and investors must be prepared to

have their capital tied up for 7-10 years

3 Provision for capital commitment – The investor needs to make provisions to have cash

available for future capital calls

4 Appropriate diversification strategy – Each private equity fund has a different investment focus

Diversification can be achieved by investing in funds in different industries, different stage of

company developments, different geographic locations

Other Issues

The framework discussed in Example 2 applies to private equity as well; each due diligence item can fall

in one of the following categories:

1 Evaluation of prospects for market success

2 Operational review

3 Financial/Legal review

In selecting funds we should also consider the following:

 historical returns generated on prior funds

 consistency of returns

 roles and capabilities of specific individuals at the fund

 stability of the team

5 Commodity Investments

Commodities are homogeneous, tangible assets and are usually traded in futures markets

The major players in the commodities market are:

 Commodity linked businesses

 Individual investors (usually for precious metals)

 Commodity trading advisors (registered advisors to managed futures funds)

5.1 The Commodity Market

LO.m: Compare indirect and direct commodity investment

The two approaches to investing in the commodities market are:

Direct commodity investment: This involves purchasing physical commodities in the cash market

Indirect commodity investment: This involves the following:

 Equity in commodity-producing companies (Note: this approach usually does not provide

effective exposure to changes in commodity prices)

 Exposure through derivative products

 Investible commodity indices

5.2 Benchmarks and Historical Performance

Benchmarks

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 (Note: unlike equity indices we cannot use market capitalization weighting

scheme for commodities)

3 Arithmetic vs Geometric Mean for Return Calculation

4 Purpose

Historical performance

Exhibit 14 provides the commodity index performance from 1996 – 2015

Stock, Bond, and Commodity

Index Performance

S&P GSCI

TR S&P

Bloomberg Barclays US Government

Bloomberg Barclays US Aggregate

Bloomberg Barclays US Corporate High Yield

CISDM CTA

EW

FTSE NAREIT

Private Equity

Correlation with commodity

Source: Schneeweis, Kazemi, and Szado (2016b)

The key points to note are:

 Commodities have a low Sharpe ratio On a stand-alone basis they have underperformed stocks

and bonds

 However commodities have a low correlation with traditional asset classes, hence adding

commodities to a portfolio can provide diversification benefits

Interpretation issues

For commodity indices to be used as benchmarks, the underlying assumption is that they are approved

in the investor’s investment policy statement as a separate asset class However, if they are not

approved as a separate asset class and instead are included within some broader asset class, then a

customized benchmark should be used to evaluate performance

While looking at historical results, the investor should consider the differences in economic conditions

between the historical period and current and future periods

5.3 Commodities: Investment Characteristics and Roles

LO.n: Describe the principal roles suggested for commodities in a portfolio and explain why some

commodity classes may provide a better hedge against inflation than others

Investment Characteristics

Commodities have a low correlation with stocks and bonds During financial and economic distress,

commodity prices tend to rise

The determinants of commodity returns are:

 Business cycle-related supply and demand

 Convenience yield: The non-monetary benefit associated with holding the underlying product

 Real options under uncertainty: A real option is an option where the underlying is a physical

asset, as opposed to a financial asset Consider an oil and gas company which uses crude oil as

raw material Owning the commodity (crude oil in this case) gives the company a valuable real

option: the option of whether to produce or not If the spot price goes up the option will be

exercised

Roles in the Portfolio

The main reasons for including commodities in the portfolio are:

 They provide a diversification benefit

 They provide a hedge against unexpected inflation Note: commodities that have consistent

demand regardless of the level of economic activity (examples: wheat, rice), provide little hedge

against unexpected inflation Commodities whose demand is linked to the level of economic

activity like energy and precious metals provide a better hedge against unexpected inflation

 Provide a natural source of return over the long term

6 Hedge Funds

The first hedge fund was established in 1940 as a long-short fund Now “hedge fund” is a much broader

term used to represent loosely regulated pooled investment vehicles

Hedge funds generally take both long and short positions and use high leverage to take advantage of

market opportunities

Hedge funds have grown in popularity (1990 AUM = $50 billion, 2005 AUM = $1 trillion, over 8000 hedge

funds)

6.1 The Hedge Fund Market

Most hedge funds seek absolute returns, therefore in theory there should be no need for a benchmark

However, some institutional investors ask for relative performance evaluation creating the need for

benchmarks

LO.o: Identify and explain the style classification of a hedge fund, given a description of its

investment strategy

Hedge fund strategies

Several hedge fund strategies have evolved over the last 15 years Some of the most popular strategies

are:

 Equity market neutral: They try to find overvalued and undervalued securities and try to keep

market risk exposure to zero by combining long and short positions

 Convertible arbitrage: They try to exploit anomalies in prices of convertible securities

 Fixed income arbitrage: They try to exploit mispricing based on interest rate expectations

 Distressed securities: They look to profit by investing in both the debt and equity of companies

that are in or near bankruptcy

 Merger arbitrage: They typically buy the stock of the target company and short the stock of the

acquiring company after a merger announcement is made

 Hedged equity: The take both long and short positions but portfolio is not structured to be

market neutral This category has the highest AUM of all strategies

 Global macro: They take advantage of systematic moves in major financial and non-financial

markets through trading in currencies, futures and option contracts

 Emerging markets: They focus on emerging and less mature markets

 Fund of funds: They invest in 10-30 hedge funds Although investors get diversification by

investing in a fund of funds, they have to pay two layers of fees

There is no standard for classification of hedge fund strategies One provider of hedge fund benchmarks

classifies strategies into the following broad groups:

 Relative value: Here the manager seeks to exploit valuation discrepancies through long and

short positions For example, equity market neutral, convertible arbitrage, and hedged equity

can be included in this category

 Event driven: Here the manager focuses on opportunities created by corporate transactions For

example merger arbitrage and distressed securities would be included in this category

 Equity hedge: Here the manager invests in long and short equity positions with varying degrees

of equity market exposure and leverage

 Global asset allocators: Here the manager opportunistically goes long and short a variety of

financial and/or nonfinancial assets

 Short selling: Here the manager shorts equities in the expectation of a market decline

LO.p: Discuss the typical structure of a hedge fund, including the fee structure, and explain the

rationale for high-water mark provisions

Fee Structure

The fee structure of hedge funds is usually a percentage of the net asset value + incentive fee For

example: 1 plus 20 fund would earn 4% if there is a 15% gain (1% + 15% x 20%)

Most hedge funds have a high water mark provision that applies to the payment of incentive fee The

previous highest net asset value level must be exceeded before performance fees are paid to the fund

manager This ensures that the hedge fund manager earns an incentive fee only once for the same gain

Most hedge funds also have a lock-up period during which no part of the investment can be withdrawn

LO.q: Describe the purpose and characteristics of fund-of-funds hedge funds

A fund of funds is a hedge funds that consists of several hedge funds They provide diversification

benefits to the investor but have an extra layer of fees Fund of funds generally have a 1.5 plus 10 fee

structure This refers to a 1.5% management fee and a 10% incentive fee

Fund of funds usually do not impose lock-out periods; therefore they provide more liquidity as

compared to other hedge funds The FOF manager holds cash buffers to facilitate withdrawals However

this can cause a cash drag on the investments

Despite of these drawbacks, FOF are good entry level investments

6.2 Benchmarks and Historical Performance

Benchmarks

When distinguishing between hedge fund indices, consider whether:

 they report monthly or daily series

 they are investable, or not

 they list actual funds used in benchmark, or not

The differences in construction of hedge fund indices are listed below:

 Selection criteria: Different funds have different rules that help determine which hedge funds

should be included in the index

 Style classification: Different indices may assign different styles to the same fund

 Weighting scheme: Different indices may assign different weights to a particular fund in the

index

 Rebalancing scheme: Some indices are rebalanced monthly, some are rebalanced annually

 Investability: Indices may or may not be directly investible

Commoditi

es

CISDM CTA EW

Real Estate

Private Equity

Historically hedge funds have performed better than traditional asset classes They also have a low

correlation with other asset classes

Exhibit 22 compares the historical performance of different hedge fund strategies with traditional asset

classes

Annualized Return

Standard Deviation

Mean Return-to- Volatility Ratio

Maximum Drawdown

Hedge Funds

S&P

500

Bloomberg Barclays US Aggregate

Bloomberg Barclays US Corp High Yield CISDM Equal

Weight Hedge Fund

Refer to Example 10 from the curriculum.

Exhibit 23 provides the factor correlations of different hedge fund strategies with traditional asset

classes

Hedge Fund S&P 500

Bloomberg Barclays US Aggregate Bond

Bloomberg Barclays US Corporate High Yield

S&P 500 Volatility

Bloomberg Barclays

US Aggregate Volatility

CISDM Equal Weight Hedge

As would be expected, equity-based hedge fund strategies are correlated with several equity and bond

market factors

Credit-sensitive strategies are correlated with similar factors as credit sensitive bond instruments

Interpretation issues

Biases in index creation: Most databases are self-reported, i.e a hedge fund manager decides which

databases to report to and provides the return data

Relevance of past data on performance: Past performance does not necessarily indicate superior

individual manager skill Research has also shown that the volatility of returns is more persistent

through time than the level of returns

Survivorship bias: Managers with poor records exit business and are removed from the database As a

result returns are overstated

Stale price bias: Lack of security trading leads to stale prices As a result the measured correlations are

understated

Backfill bias: Missing past return data for a fund is filled at the discretion of the fund when it joins an

index As a result returns are overstated

Refer to Example 11 from the curriculum

6.3 Hedge Funds: Investment Characteristics and Roles

Since the investment strategies are skill-based, fund manager selection is extremely important

Hedge funds have relatively low correlation with traditional investments

Research indicates that an equally weighted portfolio of five to seven hedge funds has similar standard

deviation as the population from which it is drawn

Refer to Exhibit 26 which shows the historical hedge fund performance

Portfolio A Equal weights S&P 500 and Bloomberg Barclays US Aggregate Bond Index

Portfolio B 90% Portfolio A and 10% hedge funds

Portfolio C 75% Portfolio A and 25% CTAs/commodities/private equity/real estate

Portfolio D 90% Portfolio C and 10% hedge fund

The important point to note is that including hedge funds in the portfolio can lead to lower skewness

and higher kurtosis which are not good for investors

Refer to Example 12 from the curriculum

Other issues

Research seems to indicate that:

 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 (Because they have

less direct impact of survivorship bias, however, classification and style drift can be an issue)

The above factors should be analyzed carefully before making a decision

Another point to note is that periods of severe drawdown may influence funds to dissolve (especially if

there is a high water mark provision)

Hedge fund due diligence

In addition to the Example 2 framework we should also consider:

 Structure of hedge fund

Refer to Example 13 from the curriculum

6.4 Performance Evaluation Concerns

LO.r: Discuss concerns involved in hedge fund performance evaluation

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

 the returns achieved;

 volatility, not only standard deviation but also downside volatility;

 what performance appraisal measures to use;

 correlations (to gain information on diversification benefits in a portfolio context);

 skewness and kurtosis because these affect risk and may qualify the conclusions drawn from a

performance appraisal measure; and

 consistency, including the period specificity of performance

Returns

The holding-period return reported by hedge funds is computed as follows:

Rate of return = [(Ending value of portfolio) - (Beginning value of portfolio)] / (Beginning value of

portfolio)

This HPR is then annualized

An important point to note is that the compounding frequency can impact performance of hedge funds

To solve the issues of leverage, the convention followed in the hedge fund industry is to “look through”

the leverage as if the assets were fully paid

Investors sometimes also calculate the rolling returns to measure the performance of a hedge fund The

rolling return is simply the moving average of the holding period returns for a specified period

The rolling return for 12 months can be calculated as:

𝑅𝑅12,𝑡= (𝑅𝑡+ 𝑅𝑡−1+ 𝑅𝑡−2+ ⋯ + 𝑅𝑡−11)/12

Volatility and Downside Volatility

When standard deviation is used to measure risk of hedge funds, it penalizes high positive returns

Hence downside deviation is used to mitigate this problem Downside deviation only computes

deviations below a specified return

𝐷𝑜𝑤𝑛𝑠𝑖𝑑𝑒 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = √∑ [min(𝑟𝑡− 𝑟

∗, 0)]2 𝑛

Sharpe ratio = (Annualized rate of return – Annualized risk-free rate)/Annualized standard deviation

However a hedge fund investor needs to understand that there are a number of limitations of the

Sharpe ratio, namely:

 It is time dependent and increases proportionally with the square root of time

 It is not an appropriate measure when the return distribution is asymmetrical

 It is biased upwards by illiquid holdings

 It is overestimated when investment returns are serially correlated

 It is primarily a risk-adjusted performance measure for stand-alone investments and does not

take into consideration the correlations with other assets in a portfolio

 It does not have predictive ability for hedge funds in general

 The Sharpe ratio can be gamed by

o Lengthening the measurement interval

o Compounding he monthly returns but calculating standard deviation from the

un-compounded monthly returns

o Writing out-of-the-money puts and calls on a portfolio

o Smoothing of returns by using certain derivatives

o Getting rid of extreme returns by using swaps or options

Sortino ratio:

Sortino ratio replaces the standard deviation in the Sharpe ratio with downside deviation Instead of

using the mean return to calculate the downside deviation, the investor’s minimum acceptable return or

risk free rate is typically used

Sortino ratio = (Annualized rate of return – Annualized risk-free rate)/Downside deviation

Gain-to-loss ratio:

This ratio measures the ratio of positive returns to negative returns over a specified period of time A

higher ratio is considered good

Gain-to-loss ratio = (Number of months with positive returns/number of months with negative returns)

x (Average up-month return/Average down-month return)

Correlations

Correlations help determine the level of diversification that can be achieved However they are most

meaningful when returns are normally distributed, which is not the case with hedge funds Hence we

also need to consider skewness and kurtosis

Skewness and Kurtosis

A negative value of skewness is undesirable Compared to a symmetric distribution, a negatively skewed

distribution will have a relatively high number of extreme losses

A distribution with high kurtosis is more peaked and has fatter tails relative to a normal distribution

Fatter tails implies more instances of extreme (both positive and negative) returns Generally high

kurtosis is considered undesirable because of the larger number extreme negative returns

Consistency

In evaluating a hedge fund investors should look at the consistency of results A fund which has

consistently outperformed the appropriate benchmark will be considered good

7 Managed Futures

Managed futures are pooled private investment vehicles that are structured as limited partnerships and

are open to accredited investors They invest in cash, spot and derivatives markets and can use leverage

Their compensation structure is similar to hedge funds They differ from hedge funds in the following

aspects:

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 with derivatives used for hedging

Trade in individual securities

Exploit inefficiencies in micro stock and bond markets

LO.s: Describe trading strategies of managed futures programs and the role of managed futures in a

portfolio

7.1 The Managed Futures Market

Managed futures are skill-based investment strategies and obtain returns from the unique skill or

strategy of the trader Individuals or institutions that provide advice related to managed futures are

called commodity trading advisors (CTA)

Trading strategies of managed futures can be classified into:

 Systematic trading strategy: Trade according to a rule-based trading model

 Discretionary trading strategy: They involve portfolio manager judgement

Generally these strategies seek absolute returns

Managed futures can also be classified by the markets they trade into:

 Financial: Trading financial futures/options, currency futures/options, and forward contracts

 Currency: Trading currency futures/options and forward contracts

 Diversified: Trading financial futures/options, currency futures/options, and forward contracts,

as well as physical commodity futures/options

7.2 Benchmarks and Historical Performance

Benchmark indices for managed futures represent a group of managers who use a similar trading

strategy or style

Investable benchmarks replicate the return to a mechanical, trend-following strategy in a number of

financial and commodity futures markets

Exhibit 29 provides the historical performance of commodity trading advisors (CTA) from 1996 – 2015

Stock, Bond, and CTA

Bloomberg Barclays US

Alternative Asset Performance Commodities Hedge Fund Real Estate Private Equity

Source: Schneeweis, Kazemi, and Tolivaisa (2016)