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

Level III

Alternative Investments Portfolio Management
Summary

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Reproduced and republished with permission from CFA Institute. All rights reserved.


Classification
Alternative investments can also be classified
according to the role they play in an investor’s
portfolio.
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Features of alternative investments
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Generally illiquid (investors demand an illiquidity premium)
Provide diversification potential
High due diligence costs
Performance appraisals are difficult because establishing
valid benchmarks is complex



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.

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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.

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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.

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

Issues to consider when using a benchmark to measure real estate performance:
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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.
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Advantages of direct equity real estate investing:
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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:
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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.

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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.
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.
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.

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

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Venture capital timeline
Formative-Stage Companies

Expansion-Stage Companies

Early Stage

Seed

Start-Up

Later Stage

First Stage

Second Stage

Third Stage

Pre-IPO

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.
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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.

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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.
2.
3.
4.

Composition
Weighting Scheme
Arithmetic vs. Geometric Mean for Return Calculation
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.
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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.

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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.

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Classification of hedge fund strategies
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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.
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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.
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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.

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Issues to consider
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.
Sharpe ratio limitations
 It is time dependent.
 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 does not take into consideration the correlations with other assets in a portfolio.
 It does not have predictive ability for hedge funds in general.

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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. Compensation and
fee structure is similar to hedge funds. They differ from hedge funds in the following aspects:
Managed Futures
Focused on derivative markets

Primarily trade market based futures and options
contracts on broader or more generic basket of assets.

Hedge Funds
Active in spot markets with derivatives used for
hedging.
Trade in individual securities.

Look for return opportunities in macro (index) stock and Exploit inefficiencies in micro stock and bond markets.
bond markets.
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.

Managed futures can also be classified by the markets they trade in:
 Financial: Trading financial futures/options, currency futures/options, and forward contracts.
 Currency: Trading currency futures/options and forward contracts.
 Diversified: Trading forwards, futures, options, as well as physical commodity futures/options.
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Distressed Securities
Distressed securities are securities of companies that are in financial distress or near bankruptcy. The securities could
be equity or debt. Investment strategies exploit the fact that:
 many investors are unable to hold below investment grade securities.
 few analysts cover distressed securities.
The different investment strategies are:
 Long-only value investing: purchase securities and hold with expectations that the company’s prospects will improve.
 Distressed debt arbitrage: Purchase bond and short equity. If the company’s prospects worsen, the value of the

company’s debt and equity should decline, but the hedge fund manager hopes that the equity, in which the fund has
a short position, will decline to a greater degree. If the company’s prospects improve, the portfolio manager hopes
that debt will appreciate at a higher rate than the equity because the initial benefits to a credit improvement accrue
to bonds as the senior claim.
 Private equity: The investor assists in the recovery or reorganization process. The objective is to increase the value of
the company by deploying the company’s assets more efficiently than in the past.
The risks associated with distressed securities are:
 Event risk: Unexpected company-specific or situation-specific risks may arise.
 Market liquidity risk: Liquidity of distressed securities is significantly less than other securities.
 J factor risk: A judge’s decision will have an impact on the investment outcome.

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