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

Advantages of direct equity real estate investing:  Good inflation hedge.. The investment can be direct or through a private equity fund.. Private equity funds are pooled investment veh

Level III

Alternative Investments Portfolio Management

Summary

Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

Features of alternative investments

 Generally illiquid (investors demand an illiquidity premium)

 Provide diversification potential

 High due diligence costs

 Performance appraisals are difficult because establishing

valid benchmarks is complex

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

Due diligence in selecting active managers

Market opportunity

Historical returns

Investment process

Organization (operational, financial, legal review)

People (track record, capability)

Terms and structure

Service providers

Documents

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

Real Estate Investments

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 Infrastructure funds

Issues to consider when using a benchmark to measure real estate performance:

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

 Real estate market lags behind publicly traded real estate securities

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

Unsmoothed indices better reflect volatility and correlations (2015 Essay Q4)

 Consider whether the benchmark represents leveraged or unleveraged investments Generally leveraged

benchmarks tend to have higher volatility and higher returns

 Consider whether the benchmark is investable or not Investable means that the underlying assets can be bought

Characteristics of real estate investments:

• Lack of liquidity

• Significant investment

• High transaction cost

• Heterogeneity

• Immobility

• Relatively low information transparency

• Diversification benefit when added to a portfolio consisting of stocks and bonds

• High correlation with the economic cycle

Advantages of direct equity real estate investing:

 Good inflation hedge

 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

Disadvantages of direct equity real estate investing:

 Most real estate cannot be divided into smaller pieces, hence they can form a large part of an investor’s total portfolio and increase 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

 Management expertise might be required

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

Private Equity/Venture Capital

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

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

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

 Deal structure and price are negotiated between the investor and company management

 Investor can request access to all information, including internal projections

 Investors typically remain heavily involved in the company after the transaction

Additionally for VC, cash flow projections are often based on limited information and need many assumptions

Other issues: ability to achieve sufficient diversification within private equity context; provision for capital commitment

Formative-Stage Companies Expansion-Stage Companies

Early Stage Later Stage Pre-IPO Seed Start-Up First Stage Second Stage Third Stage Mezzanine Stage

characteristics

Idea, first personnel hired, prototype

Moving into operation, initial revenues

Revenue growth Preparation for

IPO

Stage financing Founders, F&F,

angels, VC

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 such 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

Buyout funds:

Identify and purchase of companies at a discount to intrinsic value

Restructure operations and improve management

Exit strategies: IPOs, sale of acquired company and dividend recapitalization

Venture capital timeline

Private equity fund structure

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

Commodities Market

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

Indirect commodity investment: This involves the following:

 Equity in commodity-producing companies

 Exposure through derivative products

 Investible commodity indices

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

3 Arithmetic vs Geometric Mean for Return Calculation

4 Purpose

• Commodities have a low Sharpe ratio On a stand-alone basis they have underperformed stocks and bonds

• Commodities have a low correlation with traditional asset classes; adding commodities to a portfolio can

provide diversification benefits

• Commodities whose demand is linked to the level of economic activity like energy and precious metals

provide a good hedge against unexpected inflation

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

Hedge Funds

“Hedge fund” is a broad 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

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

 Equity market neutral: find overvalued and undervalued securities and try to keep market risk exposure to zero

by combining long and short positions

 Convertible arbitrage: exploit anomalies in prices of convertible securities

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

 Distressed securities: profit by investing in both the debt and equity of companies that are in or near

bankruptcy

 Merger arbitrage: buy the stock of the target company and short the stock of the acquiring company after a

merger announcement is made

 Hedged equity: 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: take advantage of systematic moves in major financial and non-financial markets through trading

in currencies, futures and option contracts

 Emerging markets: focus on emerging and less mature markets

Classification of hedge fund strategies

 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

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

Fund of funds

A fund of funds is a hedge fund 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

Fund of funds usually do not impose lock-out periods; more liquidity compared to other hedge funds

FOF manager holds cash buffers to facilitate withdrawals  cash drag

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 rules that 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

More on hedge funds…

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