CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz curriculum note, study session 14, reading 26

Alternative Investments Portfolio Management

1.

INTRODUCTION

Investors of alternative investments:
•
•
•
•

Defined-benefit pension funds.
Endowments.
Foundations
High-net worth individuals.

Rationale for Alternative Investments:
Risk Diversification benefits i.e.

Role of Alternative Investments:
• To meet return objectives
• To control risk
Six groups of Alternative Investments:

• Returns over time are not highly correlated with
traditional asset classes
• Broaden fund’s investment “opportunity set”
Ability to add value: Provides greater ability to investors
to add value because Alternative asset classes are less
“efficient”

2.

Return Enhancement: They can enhance total fund
return and reduce risk (volatility) over time when
combined with traditional assets.

1.
2.
3.
4.
5.
6.

Real estate
Private equity
Commodities
Hedge funds
Managed futures
Distressed securities

ALTERNATIVE INVESTMENTS: DEFINITIONS, SIMILARITIES, AND
CONTRASTS

Common features of alternative investments include:
1) Illiquidity: Relative illiquidity results in return premium
demanded by investors.
• For investors with short investment horizons,
illiquidity leads to small allocation to alternative
investments.

• Long-term investors (e.g. endowments and
defined-benefit pension funds) can make large
allocations and earn illiquidity premiums.
2) Diversification benefits: Low correlations with
traditional investments.
3) High due diligence costs for the following reasons:
a) Complex investment structures and strategies.
b) Uniqueness: Investment evaluation significantly
depends on asset class, business specific or other
expertise.
c) Lack of transparency in reporting.
4) Difficulty in establishing valid benchmark and
performance appraisal.
5) Longer time horizons.
6) Informationally less efficient relative to equity and
bonds market.
7) Offer greater opportunity to add value through skill
and superior information.

NOTE: In both alternative and traditional investments,
management fees, trading or operational expenses
need to be justified and managed.
Traditional Alternative Investments:
1) Real Estate: It refers to ownership interests in land or
structures attached to land.
2) Private Equity: It refers to ownership interests in nonpublicly traded companies.
3) Commodities: It refers to agricultural goods, metals,
petroleum.
Modern Alternative Investments: These investments
indicate investment and trading strategies (ways to

invest/style of investing).
1)
2)
3)

Hedge Funds
Managed Futures
Distressed Securities

NOTE: Alternative investment can be placed in more
than one category e.g. distressed securities investing
can be classified:
• Within private equity if debt is considered to be
private equity;
• As a subcategory of event-driven strategies under
hedge funds;
• As a separate alternative investment strategy.

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Reading 26


Reading 26

Alternative Investments Portfolio Management

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6) Service Providers: These refer to firms supporting from
outside e.g. lawyers, auditors, prime brokers, lenders etc.
7) Documents: It involves reading prospectus,
memorandum, audits etc.
8) Write-up: It involves formally documenting the entire
selection process and producing formal
recommendation of manager.
Following are the Issues that are more acute or unique
to private wealth clients than to institutional investors:
Three groups of Alternative Investments:
1) Investments that provide exposure to unique risk
factors (not provided by traditional investments) e.g. real
estate provides exposure to demographics and (longonly) commodities provide exposure to inflation.
2) Investments that provide exposure to specialized
investment strategies e.g. hedge funds and managed
futures.
3) Investments that have combined features of
exposure to unique risk factors and investment strategies
e.g. private equity funds and distressed securities.
Due Diligence process in Alternative Investments
involve the following steps:
1) Market Opportunity: It involves identifying investment
opportunities in the market, their causes and their
chances of persistence. It is done by analyzing capital
markets and types of managers operating within those
markets.

Tax issues: Alternative investments frequently involve
partnerships and other structures that have distinct and

peculiar tax issues.
Determining suitability: Determining suitability of
investment is more complex in case of an individual
client or family than for an institutional investor because
of:
• Uncertain time horizons of individual clients.
• Emotional or financial needs of a client.
Communication with client: Individuals are
nonprofessional investors and have less knowledge,
therefore, it is difficult for an advisor to communicate
and discuss suitability of investment in the portfolio with
them.
Decision risk: It refers to irrational trading/changing
strategies at the point of maximum loss. Decision risk
increases due to the strategies with following
characteristics:

2) Investment process: It involves evaluating managers’
comparative advantage etc.

• Strategy that involves negatively skewed returns.
• Strategies that involve high kurtosis.

3) Organization: It involves valuating stability of the firm
and how well it is organized i.e. Consistent investment
philosophy, less management (staff) turnover, fair
compensation, succession plans etc.

Note: investors prefer positive skewness and moderate or
low kurtosis.

4) People: It involves analyzing experience, intelligence,
integrity of the people in the firm.
5) Terms and Structure: It refers to time and amount of
investment and requires evaluating fair terms, alignment
of interests, properly structured account etc.
3.

Real estate plays an important role in both institutional
and individual investor portfolios.
Note: The focus of this reading is only Equity investments
in real estate.

Concentrated equity position of the client in a closely
held company: It is necessary to take into account the
effect of investment on the client’s risk and liquidity
position when ownership in a closely held company
represents a substantial part of wealth of the client.
NOTE: In core-satellite investing, alternative investments
usually are included in the satellite ring for most investors.
REAL ESTATE

3.1

The Real Estate Market

Rationale for investment in Real Estate by institutional
investors
i.
ii.

To diversify their portfolios
To hedge against inflation


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Alternative Investments Portfolio Management

3.1.1) Types of Real Estate Investments
A. Direct ownership includes:
1. Investment in residences
2. Business (commercial) real estate
i. Industrial
ii. Apartments
iii. Offices
iv. Retail
3. Agricultural land
B. Indirect investment (also known as financial
ownership) includes investing in:
1. Companies engaged in real estate ownership,
development or management i.e. homebuilders
and real estate operating companies.
2. Real estate investment trusts (REITs) are publicly
traded equities representing pools of money
invested in real estate properties and/or real
estate debt.
3. Commingled real estate funds (CREFs) are
privately traded equities representing significant
commingled (i.e. pooled) investment in real

estate properties.
4. Separately managed accounts managed by real
estate advisors like in case of CREFs
5. Infrastructure funds are private investment in
public infrastructure projects i.e. roads, schools,
bridges, airports etc. with rights to receive
specified revenue streams over a contracted
period.
Types of REITs:
1. Equity REITs: Own and operate income-producing
real estate i.e. office buildings, apartment buildings and
shopping centers.
• Shareholders receive rental income and income
from capital appreciation if the property is sold for
a gain.

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2) REITs are highly liquid as their shares trade on
major exchanges.
3) REITs allow smaller investors to get real estate
exposure.
4) ETFs, mutual funds and traded closed-end
investment companies allow investors to obtain a
professionally managed diversified portfolio of
real estate securities with a relatively small outlay.
Disadvantages:
1) REIT returns are more volatile than real estate
returns (due to public trading).
2) REITs have relatively higher correlation with

equities than real estate prices.
Risk Hedging properties:
• Hold property and want to sell it in future, short
REITs index to hedge risk.
• Want to buy property, long REITs index.
CREFs:
• CREFs include open-end funds and closed-end
funds.
• CREFs are used by institutional and wealthy
individual investors to access the real estate
expertise of a professional real estate fund
manager.
• In contrast to open-end funds, closed-end funds
are usually leveraged and have higher return
objectives (due to high risk);
3.1.2) Size of the Real Estate Market
According to estimates, real estate represents one-third
to one-half of the world’s wealth.
3.2

Benchmarks and Historical Performance
3.2.1) Benchmarks

2. Mortgage REITs: Mortgage REITs deal in the
investment and ownership of property mortgages;
• They loan money for mortgages to owners and
operators of real estate or
• Invest in (purchase) existing mortgages or
mortgage-backed securities.
• Shareholders receive interest income on

mortgage loans and capital appreciation income
from improvement in the prices of loans.
3. Hybrid REITs: Hybrid REITs invest in both mortgages
and properties, combining the investment strategies of
Equity REITs and Mortgage REITs.
Advantages of REITs:
1) REITs securitize illiquid real estate assets.

NCREIF Index: The principal benchmark used to measure
the performance of direct real estate investment is the
National Council of Real Estate Investment Fiduciaries
Property Index.
Characteristics:
• It is issued quarterly.
• It covers a sample of commercial properties
owned by large institutions.
• Value-weighted index
• Includes sub-indices grouped by real estate
sector (apartment, industrial, office and retail)
and geographical region.
• Values are determined by property appraisals
and conducted infrequently.
• Ownership change is infrequent.
• Smoothing effect due to appraised values: The


Reading 26

Alternative Investments Portfolio Management

use of appraised values tends to
o Smooth the returns
o Underestimate volatility in underlying values
o Understate correlations with other assets
o Overstate benefits of real estate in the portfolio
• It is not an investable index (for performance
appraisal).
• NCREIF
Index
represents
non-leveraged
investment only.
• NCREIF Index most accurately represents the
performance of private real estate funds.
Important Note: Using unsmoothed NCREIF Index more
accurately reflects the benefits of real estate investment.

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NCREIF Index.
• When NCREIF is unsmoothed, volatility more than
doubles but return is increased by a small
amount.
• Securitized real estate investments are poor
substitutes for direct investment because:
o Smooth NCREIF Index and Unsmooth NCREIF
Index have high positive correlation (i.e. 0.71).
o The correlation between unhedged NAREIT
Index and NCREIF Index is 0.
o The correlation between unhedged NAREIT

Index and unsmoothed NCREIF Index is 0.21.
Timberland and Farmland:

NAREIT Index: The principal benchmark used to
represent indirect investment in real estate is the NAREIT
Index.

•
•

• It is a real time market (cap) weighted index of all
REITs actively traded on the exchange.
• It computes a monthly index based on monthend share prices of REITs that own and manage
real estate assets or equity REITs.
• REITs provide a levered exposure to real estate (>
50% of capital structure is represented by debt).
Therefore, they have higher risk (higher S.D)
relative to unsmoothed NCREIF Index.

•

3.3

Investing in timberland and farmland provides
potential for substantial income and capital
appreciation but bears limited liquidity.
Farmland returns rely on value of land and
prices of agriculture commodities
Timberland returns depend on land value and
lumber prices. The demand side of lumber

depends on the housing starts and the supply
side depends on the environmental conditions.
Investors can also invest in timber through
timberland REITs.
Real Estate: Investment Characteristics and Roles

Hedged REITs: Long REITs + Short Futures
• The hedged NAREIT Index is a more realistic
representation of the underlying real estate
market and has high correlation with the
unsmoothed NCREIF Index than without
correction (although hedging is imperfect).
• Hedged NAREIT Index is preferred because it
eliminates double counting of equity return
component in equity REITs. It results in increase in
return, decrease in risk and increase in Sharpe
ratio.
3.2.2) Historical Performance
• It has been observed that the real estate market
lags behind publicly traded real estate securities.
• Direct and indirect real estate investments
produced better risk-adjusted performance over
1990-2004 period relative to general stocks and
commodities.

Real estate represents a major portion of many
individuals’ wealth. However, the clients’ residences are
not considered “marketable” and therefore, are not
included in strategic asset allocation.
3.3.1) Investment Characteristics

Following are some of the investment characteristics of
physical real estate market:
1)
2)
3)
4)
5)
6)

Relative Lack of liquidity
Large lot sizes and not divisible
Relatively high transaction costs
Heterogeneity
Immobility (fixed location)
Relatively low information transparency (seller has
informational advantage relative to buyers)
7) Not easily traded due to market inefficiencies
8) Investment is long-term
Implication:

Difference between performance properties of direct
and securitized real estate investment
REITs
(Indirect)
High return
High S.D.
Higher Volatility

Direct
(or appraisal-based)

Low returns
Low S.D
Low volatility due to
stale valuations

• Downside bias is corrected by “un-smoothing” the

1) These characteristics provide opportunity to
generate relatively high risk-adjusted returns for
investors who can obtain cost-efficient and high
quality information.
2) Due to lack of reliable and high frequency
transaction data for properties, valuations are
appraisal-based.
Effect of market and economic factors on real estate:


Reading 26

Alternative Investments Portfolio Management

• Interest rates directly or indirectly affect demand
and supply for real estate by affecting factors i.e.
business financing costs, employment levels,
savings habits and the demand and supply for
mortgage financing.
• Worldwide, the returns to real estate are positively
correlated with changes in GDP.
• In the long run, population growth positively
affects real estate returns.

Inflation-hedging: There are mixed conclusions
regarding the inflation-hedging capabilities of real
estate investment. Overall, direct real estate investment
can provide an inflation hedge to some degree.
Real estate values are affected by idiosyncratic
variables i.e. location. This implies that:

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property compared to flexibility of trading small
amounts in REITs on public exchanges.
• The lack of availability and timeliness of
information results in extensive valuation and due
diligence issues.
3) High cost of acquiring information because of
heterogeneity of real estate.
4) High transaction costs because of high commissions
charged by real estate brokers relative to securities
transaction fees. Exchange traded REITs have low
transaction costs and reallocation of funds is easy.
5) High Operating costs i.e. greater maintenance,
operating and administrative costs and hands-on
management.

• Complete diversification in real estate can be
achieved only by investing internationally.
• Optimal diversification can be obtained by
selecting one country from each continent.

6) Locality Risk: Have greater exposure to

neighborhood deterioration and conditions that are not
under investors’ control.

Advantages of DIRECT INVESTMENT in real estate (for
both institutional and individual investors):

7) Political risks associated with tax benefits i.e. income
tax deductions can be discontinued in case of changes
in tax laws.

1) Tax benefits: Mortgage interest, property taxes and
other expenses are tax deductible which benefits
taxable owners of real estate.
2) Use of high leverage: Greater financial leverage can
be used in mortgage loans compared to securities
investing.
3) High control over investment: Real estate investors
have direct control over their property and are able to
expand or modernize property to increase its market
value.
4) Geographical Diversification: The values of real
estate investments in different locations have low
correlations; thus, it can be used to reduce exposures to
catastrophic risks e.g. floods etc.
5) Low volatility: Real estate returns (on average) have
relatively low volatility compared to public equities
even after correcting for downward bias.
6) Greater diversification benefits: Direct real estate has
lower correlations with U.S. equities and bonds relative
to REITs’ correlations.

Disadvantages:
1) Large size and indivisibility: Direct investment in real
estate is usually in large lots and is not easy to divide into
smaller pieces. Consequently, these properties constitute
a major portion of an investor’s total portfolio and
investors have to deal with large idiosyncratic risks
associated with these investments.
2) Illiquid relative to securitized real estate due to:
• Large transaction sizes when buying/selling

3.2.2) Roles in the Portfolio
Real estate is affected by many economic
fundamentals and economic cycles. Thus, these
investments can be used for tactical allocation purposes
by forecasting economic cycles that would positively
affect these investments.
Real estate has a potential to add value through active
management.
Real estate also provides diversification benefits.
• Historically, direct investment in real estate has
shown low correlation with other assets.
• Real estate investments are less affected by shortterm economic conditions and therefore, have
lower volatility than other asset classes.
Good income enhancer: Income producing commercial
real estate is considered a relatively stable investment.
Real Estate Performance in Portfolios:
Adding REITs to traditional portfolio of equities and bonds
results in higher Sharpe ratio.
It does not provide diversification benefits when added
to a portfolio consisting of stock/bond/ hedge funds and

commodity.
Unsmoothed NCREIF Index has negative correlation with
S&P 500 and bonds; this results in increase in Sharpe ratio
when unsmoothed NCREIF Index is added to stock/bond
portfolio.
However, Sharpe ratio is slightly increased when
unsmoothed NCREIF Index is added to stock/bond


Reading 26

Alternative Investments Portfolio Management

portfolio with the added exposure of hedge funds and
commodities.

3) Unlike indirect investments, direct investments exhibit
high degree of persistence in returns i.e. positive
following positive and negative following negative.

Conclusion: Direct real estate investment provides
diversification benefits to stocks and bonds but benefits
disappear when hedge funds and commodities are
added to the portfolio.
Diversification within Real Estate Itself: Diversification
within real estate investing can be obtained through
type and geography. Investments in different real estate
sectors have different risk and return profiles.

Practice: Example 5,

Volume 5, Reading 26.

Rationale for including real estate in a multi-asset
portfolio:

Large office assets:
•
•
•
•

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1. Real estate has a low correlation with stocks and
bonds.
2. Real estate (historically) has shown a high riskadjusted rate of return relative to stocks and
bonds.
3. Real estate has a positive correlation with both
anticipated and unanticipated inflation and
therefore provides an inflation hedge.

Higher risk
Higher volatility
Lower risk-adjusted returns
More pronounced impact of market cycles

Apartments:
• Lower risk
• Lower volatility
• Higher risk-adjusted returns (due to low correlation

with inflation)
Properties of Return Distribution of Real Estate:
1) Due to illiquid market (Direct investment), returns tend
to be close to zero.
2) Both direct and indirect investments have nonnormal distribution.
4.

PRIVATE EQUITY/VENTURE CAPITAL

Private equity is an ownership interest in a private (nonpublicly) company. It includes start-up companies,
middle-market private companies and private
investment in public entities (PIPE).

• Preferred stock is senior to common stocks both in
terms of its profit share and liquidation value.
• Shares issued in later rounds of financing are
senior to previously issued preferred stocks (all else
constant).
• Events i.e. buyouts or acquisition of the common
equity at a favorable price triggers the conversion
of preferred stocks into common stocks.

Characteristics:
• Private equity is not registered with a regulatory
body.
• These involve Private placements i.e. sale offers to
either institutions or high-net-worth individuals
(accredited investors).
• Private equity plays a growth role in investment
portfolios.

• Risk is controlled and evaluated through
appropriate due diligence processes.
4.1.1) Types of Private Equity Investment
1)

Direct Investment: It refers to purchasing claim
directly from the company that needs financing.
• Structured as convertible preferred stock rather
than common stock.

2)

Indirect Investment: It is primarily done through
private equity funds i.e. VC and buyout funds.
• Structured as limited partnerships or limited liability
companies (LLCs).
• Have an expected life of 7-10 years with 1-5 years
extension option.
• Commitment/offering period defines how
committed funds will be requested over time.
• Investment in private equity is mostly done via
private equity funds.

Advantages of Limited Partnerships and LLCs:


Reading 26

i.
ii.

Alternative Investments Portfolio Management

Avoid double taxation.
Liability of limited partners or shareholders is
limited to their amount of investment.

General partner (managing director in LLCs): He is the
venture capitalist who selects and advises investments to
investors. He also commits his own capital, which is
helpful in closely aligning interest of outside investors and
the fund manager.
Limited partners: Refer to shareholders of LLCs or limited
partnerships.

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• Restructuring operations and improving
management.
• Purchasing companies at a discount to their
intrinsic value.
• Creating gains by adding debt or restructuring of
existing debt.
These funds seek to reduce costs and increase revenues
and for this purpose, they generally maintain a pool of
experienced operating and financial executives to be
added to companies if necessary or appropriate.
Value gains can be realized through:

NOTE:

• Private equity funds usually do not maintain a
pool of uninvested capital.
• Private equity funds of funds are also available.
Private equity funds: These are pooled investment
vehicles through which many investors make indirect
investments in generally highly illiquid assets.
Major forms include
a) Venture Capital (early, mid and late-stage): Private
capital used to finance a start-up (new) business or
growing private companies.
Characteristics:
• Venture capital investments are private, nonexchange-traded equity investments.
• Investments are usually made through limited
partnerships.
• Due to illiquidity and high risk, relatively high
returns are expected.
• Private company eventually converts into publicly
owned company.
• Have Capacity issues i.e. limited investment
opportunities
• Requires distinct knowledge and experience
b) Buyout Funds/Buyouts: Acquisition of an established
company or an operating division via private equity
funds known as buyout funds.
• Publicly owned company is converted into
private.
• Buyout funds constitute a large portion of private
equity fund relative to VC funds in terms of AUM
or size of capital commitments.
Types of buyout funds:

1) Mega-cap buyout funds: These funds take public
companies private.
2) Middle-market buy-out funds: These funds purchase
private companies (established and/or divisions spun-off
from larger companies), which are not able to access
capital from public due to small revenues and profits.
Value in these companies is added through:

a) Sale of the acquired company.
b) IPO
c) Dividend Recapitalization i.e. debt is issued to
finance special dividends to owners.
• Advantage: Facilitate investors to recover all or
most of the investment within 2-4 years of the
buyout along with the retention of ownership
control.
• Disadvantage: Due to high leverage involved, a
company may become weak.
1) Private Investment in Public Entity (PIPE):It refers to
making a relatively large investment in a public
company usually at a significant discount when the
share price of a publicly traded company drops
significantly.
Investors of Private Equity include:
•
•
•
•
•
•

Pension plans
Endowments
Foundations
Corporations
Family offices
Other advisors to the private wealth market

NOTE: Private placement memorandum: A document
used for the purpose of raising funds through an agent.
Private Equity
Investments

Publicly Traded Securities

Structure and Valuation
Price and deal structure
are determined through
private negotiation
between the investor
and company
management.

Price is determined by
market.
Deal structure is
standardized.
Securities regulators
approve variations.

Access to Information for Investment Selection
Investors can have
access to all information
(including internal
projections)

Investors have access to
only publicly available
information.

Post-Investment Activity


Reading 26

Alternative Investments Portfolio Management

Private Equity
Investments

Publicly Traded Securities

Investors remain
significantly involved in
the management of the
company after
investment and
participate at board
level as well.

Investors have limited
access to management
and do not participate at
board level.

Practice: Exhibit 9,
Volume 5, Reading 26.

4.1

The Private Equity Market

The Demand for/Issuers of Venture Capital:
1.

Formative-stage / start-up companies:
• Newly formed companies and/or young
companies beginning product development.
• Companies just start selling a product (through
marketing an effective business plan to
potentially interested parties).
• Most Venture Capitalists are not interested in
companies at their earliest stage.

2.

Expansion-stage companies:
• Young companies that need funds to expand
sales.
• Established companies with significant revenues

(middle-market companies)
• Companies preparing for an IPO.

Financing stages of a private company include:
1. Early-stage Financing: It is used by Formative-stage
Companies. It involves following sub-stages:
Seed: In seed stage, small amount of money is provided
to form a company or to prove commercial success of a
business idea.
• Characteristics: Incorporation of business idea,
first personnel is employed, development of
prototype.
• Buyers/financing: Founders, FF&Fs, angel investors,
venture capital
• Purpose of financing: To support market research
and to establish a business.
Start-up: In this stage, a company has been formed and
idea has been proven but funds are needed to
commercialize the product or idea.
• Characteristics: Pre-revenue stage i.e. revenue
has not yet started.
• Buyers/financing: Angel investors and venture

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capital.
• Purpose of financing: To support product
development and initial marketing.
First-stage: When a company has been through seed
and start-up stages and needs additional financing.

• Characteristics: Operation has started and
revenue starts to initiate.
• Buyers/financing: Angel investors and venture
capital.
• Purpose of financing: To support initial
manufacturing and sales.
2. Later-stage Financing: It is used by Expansion-stage
Companies who need funds to expand sales. It involves
following sub-stages:
Second-stage:
• Characteristics: A company that is already
producing and selling a product and revenue
starts to grow.
• Buyers/financing: Venture capital, strategic
partners.
• Purpose of financing: To support initial expansion
of a company.
Third-stage:
• Characteristics: Revenue starts to grow
• Buyers/financing: Venture capital, strategic
partners
• Purpose of financing: To provide funds for major
expansion.
Pre-IPO: It refers to mezzanine stage.
• Characteristics: IPO preparation.
• Buyers/financing: Venture capital, strategic
partners
• Purpose of Mezzanine (bridge) financing: To
provide funds to prepare for an IPO (mix of debt
& equity).

3. The Exit: The exit of a private equity is difficult.
Following are ways to exit:
a) Merger with another company
b) Acquisition by another company
c) IPO
In case of failure of venture, business can be closed
without any recovery of the original investment by the
equity holder.


Reading 26

Formative-Stage
Companies

Early
Stage

Alternative Investments Portfolio Management

Seed

Stage
Financing
(buyers of
private
equity)

Purpose of Financing

Idea
incorporation,
hiring of 1st
personnel,
prototype
development

Founder,
FF&F,
angles,
venture
capital

Supports market research
and establishment of
business

Movement
into operation,
initial revenues

Angles,
venture
capital

Supports product
development & initial
marketing
Supports initial
manufacturing & sales

Revenue
Growth

Venture
capital,
strategic
partners

Supports initial expansion
of a company already
producing & selling a
product
Provides capital for major
expansion

Start-Up

First Stage
Expansion-Stage
Companies

Stage
Characteristics

Later
Stage

Second Stage

Third Stage

PreIPO

Mezzanine

Preparation
for IPO

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Provides capital to
prepare for the IPO-often
a mix of debt & equity

Reference: CFAI Curriculum,
Reading 26, Exhibit 10

The Supply of Venture Capital: Suppliers of venture
capital include the following.

and the investors are often referred to as
“strategic partners”.
• These funds are not available to the public.

1) Angel investors: The first outside investors in a
company.
• Invest in seed and early-stage companies.
• Invest relatively a small amount.
• These investments are considered to be the

riskiest because of early stage of business.
2) Venture Capital (VC): Dedicated Pools of capital
managed by specialists (venture capitalists) that provide
equity or equity-linked financing to privately held
companies. An individual pool is known as venture
capital fund.
Compensation of the Fund Manager:
• VC identifies companies with attractive business
opportunities.
• Provide financial and strategic support and
expertise in related fields.
3) Large Companies: Major companies invest in
promising young companies in the same or related
businesses.
• This investment is known as corporate venturing

Management fee + Incentive fee
A. Management fee is usually a % of committed
funds(not the amount actually invested). It ranges 1.5 –
2.5% and decreases over a period of time to reflect
lower work load in later years of partnership.
B. Incentive fee (a.k.a carried interest): It is the share of
the private equity fund’s profit earned by manager after
the fund has returned the outside investor’s capital (i.e.


Reading 26

Alternative Investments Portfolio Management

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profits that represent a return >hurdle rate or preferred
rate). It is expressed as % of total profits of a fund i.e. 20%.

Interpretational Issues: Incorrect returns are estimated
due to:

C. Clawback provision: It is a provision to penalize the
manager for bad performance in later years i.e.
manager is required to return money to investors if at the
end of a fund’s life investors have not received back
their capital contributions and contractual share of
profits.

• Use of appraised values (stale data).
• Significant effect of company-specific events.
• Non-standardized method of appraisals.

Distribution of cashflows:
• First of all invested capital and preferred return is
distributed to investors.
• Sometimes, manager is allowed to take small % of
early distributions.
• When all or most of the cash flows are distributed to
investors, in the following years there is a catch up
period in which the manager receives all or most of
the profits.
• Subsequent profits are then distributed to investors
according to carried interest %, for example 80% to

investors and 20% to manager.
• Some of the profits of the manager can be placed
in an escrow account to meet claw-back liability, if
any.

Vintage year Effects: The effect of vintage year (closing
year of a fund) on fund’s returns is known as vintage
year effect. Investors should take into account vintage
year effects when comparing performance of different
private equity funds.
4.3

Investment Characteristics and Roles of Private
Equity

1) Illiquidity: Private equity investments are generally
highly illiquid. Convertible preferred stock investments do
not trade in the secondary market.
2) Long-term commitments: Private equity investment
requires long-term commitments. Time horizon can also
be quite uncertain for direct VC investments.
3) Higher risk than seasoned public equity investment:
Return: On average, returns have higher dispersion than
public equity.

4.1.2) Size of the Private Equity Market
According to a reliable study, by 2006, around US$200
billion was invested in private equity VC and buyout
funds via approximately 1,000 private equity vehicles.
4.2

Risk: Risk of complete loss of investment is higher. New
and young businesses have higher failure rate.
4) High expected IRR required: Investors require high
target return to compensate for higher risk and illiquidity.

Benchmarks and Historical Performance
Characteristics of VC investments further include:

In private equity, events through which market price can
be determined include:
•
•
•
•

5)

• Ventures operate in new markets.
• Cash flows projections are based on limited
information available and assumptions.

New funds raising
Company acquisition by another company
IPO
Failure of the business
6)

Benchmarks: Benchmarks include:
i.

ii.

Cambridge association and Thomson Venture
Economics
Custom benchmarks

Construction: Value depends on specific events.
Benchmarks are constructed for VC and buyouts.
Biases: Infrequent pricing process creates problems for
index construction as a result of stale values.
Historical Performance: Private equity returns have
exhibited low correlation with publicly traded securities
which indicates that they can contribute to portfolio
value addition. However, low correlation might exist
because of use of stale prices due to lack of observable
market prices for private equity.

Limited information:

High upside potential for successful ventures.

Differences between VC funds and Buyout funds:
• Buyout funds are usually highly leveraged. In
contrast, VC funds do not use debt to obtain their
equity interests.
• Buyout funds have earlier and steadier cashflows
relative to VC funds. Note that Buyout funds are
able to realize returns earlier due to purchase of
established companies.
Note: The earlier the stage in which a fund invests in

companies, the greater the risk and the higher the return
potential.
• Buyout funds have less error in value
measurement.
• VC investing (relative to buyout funds) are
associated with frequent losses and higher upside


Reading 26

Alternative Investments Portfolio Management

potential when investments are successful.
• Buyout funds investment involves less risk and
earlier returns.

Practice: Example 9,
Volume 5, Reading 26.
Treatment of nonmarketable interest:
• The discount for a minority interest reflects the lack
of control that the investor has over the business
and distributions i.e.
Minority interest discount ($) = marketable
controlling interest value ($) × minority interest(%)
discount = (investor’s interest in the equity × total
equity value) × minority interest discount(%)
Marketable minority interest ($) = Marketable
controlling interest value ($) – minority interest
discount ($)
• Discount for lack of marketability (marketability

discount) reflects the lack of liquidity in the
investment and depends on factors i.e. size of the
interest and level of dividends paid.
Marketability discount ($) = Marketable minority interest
($) × marketability discount (%)
Non-Marketable minority interest ($) = Marketable
minority interest ($) - marketability discount ($)
• In case of valuing a controlling interest, we need to
consider only the marketability discount.
• In case of valuing a majority interest, the discount
for lack of marketability reflects both the cost of
going public and a discount for owning a large
block of shares.

Practice: Example 8,
Volume 5, Reading 26.

4.3.2) Roles in the Portfolio
Private equity has positive correlation with public equity
because all types of businesses are exposed to
economic and industry conditions. However, correlation
is low due to high company-specific risk involved in
private equity.
VC fund is expected to generate higher returns in case
of advancing public equity market values.
The primary role of Private equity is return enhancement;
however, it can play a moderate role as risk diversifier.
Issues involved in formulating a strategy for private
equity investment:

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1) Sufficient diversification requires large number of
positions: Investors with greater than $100 million portfolio
value are able to invest in investments required for
diversification. Private equity FOFs are preferable for
small investors to achieve diversification (in spite of
higher fees).
2) Low Liquidity of the position: Direct private equity
investments are inherently illiquid.
• Capital has to be tied up for 7-10 years.
• Limited secondary market exists for private equity
commitments.
• Investments trade at highly discounted prices.
3) Provision for capital commitment:
• Investors make a commitment of capital.
• Cash is requested over the commitment period
(usually 5 years).
• Investors are required to provide capital when
future capital calls are made.
4) Appropriate diversification strategy: Both the stand
alone risk factors of an investment and its effect on the
overall risk of portfolio should be taken into account.
Diversification may be across industry sectors (IT, biotech
etc.), by stage of company development (early stage,
expansion, buyout etc.) and by location (local,
international etc.).
Due Diligence items for private equity:
1) Evaluation of prospects for market success: It includes
• Markets, competition and sales prospects.

• Management experience and capabilities;
assessment of management is an ongoing process.
• Management’s commitment: Following factors are
used to assess management’s commitment:
i. Percentage ownership: ownership of a large
portion of the company is an indication of high
commitment to the company.
ii. Compensation incentives: managers’ interests
must be aligned with the shareholders through
proper compensation arrangements.
• Cash invested by managers: Greater cash invested
by managers indicates highly committed
management team.
• Opinion of customers: Customers’ opinion of the
company’s existing product/service should be
evaluated.
• Identity of current investors: Presence of
professional/expert investors related to company
business give an indication of company’s future
success.


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Alternative Investments Portfolio Management

2) Operational Review: It includes
• Expert validation of technology i.e. technology that
is marketed by a company is valid and represents
future advancement.

• Employment Contracts i.e. investors should
evaluate whether key employees have contracts to
stay with the company.
• Intellectual property i.e. investors should evaluate
whether the company possesses relevant patents.

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• Examination of financial statements: Investors
should analyze financial statements, tax returns and
conduct their own audits etc.
Factors to be considered in evaluating manager’s team
(Indirect investment):
• Historical returns generated in prior funds.
• Consistency of returns.
• Roles and capabilities of specific individuals in the
fund.
• Stability of the team and personnel turnover.

3) Financial/ legal review: It includes
• Potential for dilution of interest: Investors should
evaluate existence of stock options and other
means which can dilute their investment interests.

5.

COMMODITY INVESTMENTS

A commodity is a homogeneous and tangible asset.

• Gives unequal fixed weights to each sector
according to its perceived relative importance.

Types of Commodity Investments
1. Direct Commodity Investment: Refers to cash (spot)
market purchase of physical commodities or exposure
via derivatives i.e. futures.

2.

• Includes energy, metals, grains, and soft
commodities (i.e. cocoa, coffee, cotton & sugar).
• Uses world production weighting system.
• Weights are assigned on the basis of five year
moving average of world production.
• The energy sector is over weighted in the index.
• Provides two versions of indices:
i. Total return version: It assumes that capital is
required to purchase basket of commodities is
invested at the risk-free rate.
ii. Spot version: It tracks movements in futures
prices only.
• Sub-indices include agriculture, industrial, livestock,
energy precious metals contracts.

• Due to carrying and storage costs associated with
Cash market purchases, derivatives and/or indirect
commodity investments are preferred by investors.
• Derivatives/futures provide good commodity
exposure.

2. Indirect Commodity Investment: Refers to achieving
indirect exposures to changes in spot market values of
commodities via e.g. investing in equity of companies
specializing in commodity production etc.
• They do not provide effective exposure to
commodity price changes because these
companies themselves hedge commodity risk.
• ETFs provide partial effective commodity exposure.
The creation of investable commodity indices and
increase in preference to use derivative markets to gain
commodity exposure has facilitated small investors to
access commodity markets via mutual funds or
exchange-traded funds.
5.2

Benchmarks and Historical Performance

Commodities physical markets are not centralized.
Therefore, performance of commodity investment can
be evaluated through commodity indices.
Benchmarks:
1.

Reuter Jefferies/Commodity Research Bureau
(RJ/CRB) Index:
• Groups commodities into four sectors.

Goldman Sachs Commodity Index (GSCI):

3.

4.

Dow Jones-AIG Commodity Index.
S&P Commodity Index.

Construction: Benchmarks are constructed using a
futures-based strategy.
Bias: Indices differ in composition, weighting scheme
and purpose.
Important Notes:
• Market cap weighting scheme cannot be used in
commodity futures indices because every long
futures position has a corresponding short futures
position and market cap of futures contract is
always zero.
• Generally, return on commodity futures contract is
not equal to the return on the underlying spot
commodity. However, Cost of carry model, ensures
that the return on a fully margined position in a


Reading 26

Alternative Investments Portfolio Management

futures contract closely replicates the return on an
underlying spot deliverable.
Historical performance:
The difference in performance of different indices can
be attributed to the differences in the components of

the indices and weighting systems.
• On a stand-alone basis, commodities have
underperformed traditional investments (stocks &
bonds) i.e. exhibited relatively low Sharpe ratio.
• Commodities provide diversification benefits
because commodities indices have low correlation
with traditional asset classes.
• Energy sector plays a significant role in the positive
Sharpe ratio and high volatility of the GSCI.
• Average correlation of GSCI commodity sector
returns is low; thus, commodities do not represent a
homogeneous market of similar investments.
Recent Performance: Recent performance indicates
that:
• All commodity indices outperformed U.S. and world
equities but underperformed bonds.
• Correlations with bonds have increased; however,
correlations among commodities and traditional
asset classes are low.
Commodity Index Return Components: Returns on
Commodity futures contract have three components:
Total Return on a Commodity Index = Collateral Return +
Roll Return + Spot Return
1. Spot Return/Price Return: It measures the change in
commodity futures prices that should result from
changes in the underlying spot prices. It is calculated as
change in the spot price of the underlying commodity
over a specified time period.
Because of carrying and storage costs, when spot price
increases (decreases), futures price increases

(decreases) and results in positive (negative) return to a
long position. (Note that convenience yield is already
adjusted in the cost of carry model).
2. Collateral Return/ yield: When an investor (long
futures contract) has a fully margined position (i.e. posts
100% margin in the form of T-bills), he/she can earn riskfree interest rate. This return is known as collateral return.
3. Roll Return/ yield: Roll yield can be earned by rolling
long futures positions forward through time.
Backwardation: It occurs when longer maturity futures
contracts have lower price i.e. downward sloping term
structure of futures prices. In this situation, positive return
can be earned through buy-and-hold strategy i.e. when
futures price < spot price, it increases over time
(converges to spot price) as it gets closer to maturity and
generates positive roll yield.

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Contango: It occurs when longer maturity futures
contracts have higher price i.e. upward sloping term
structure of futures prices.
Monthly Roll Return = ∆ in futures contract price over the
month - ∆ in spot price over the month
Note: The closer the futures contract to maturity, the
greater the roll return/yield.
Convenience yield: It refers to nonmonetary benefits
from owning the spot commodity. It is directly related to
roll yield i.e. the higher (lower) the convenience yield,
the higher (lower) the roll returns. It increases during
periods of high volatility and demand & supply shocks. In

addition, it is inversely related to the level of inventory.
5.2.3) Interpretation Issues
• When commodities are treated as a distinct asset
class then commodity indices can be used as
benchmarks.
• When commodities are not treated as a distinct
asset class then a customized benchmark should
be used.
• It is necessary to take into account the
differences in economic conditions between
historical period and current and forecasted
future period.
5.3

Commodities: Investment Characteristics And
Roles

Characteristics:
In periods of financial and economic distress,
commodity prices tend to rise and potentially provide
valuable diversification benefits.
Commodities are generally business-cycle sensitive
because of their sources of returns and their
demand/supply is dependent on business-cycle.
Commodities have low or negative correlation with
stocks and bonds.
Reasons behind low correlation:
• Commodities have positive correlation with
inflation whereas stocks & bonds have negative
correlation with inflation.

• Commodity futures prices are more affected by
short term expectations; stocks and bonds are
affected by long term expectations.
• Commodity prices decrease when economy
weakens.
Rationale for including commodities in portfolio:
Act as an inflation hedge: They protect portfolio against
unexpected inflation.
Portfolio risk diversifier: They provide (both long-term and
short-term) diversification benefits.


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Alternative Investments Portfolio Management

Potential for improvement in the Sharpe ratio.
Determinants of commodity returns:
Business cycle-related supply and demand: Prices
are determined by supply and demand of the
underlying commodities.
Convenience Yield: Difference b/w spot price and
futures price is based on 3 components:

1)

2)

i.

Opportunity costs i.e. forgone interest from
purchasing and storing commodity
Storage costs
Commodity’s convenience yield

ii.
iii.

Real Options under Uncertainty: Producers hold
valuable real options (option to produce or not to
produce) i.e. production occurs only when spot
prices > discounted futures prices.

3)

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Role of Commodities as Inflation Hedge:
Storable commodities (e.g. energy, precious metals) are
directly related to the intensity of the economic activity
and provide superior inflation hedging.
Non-storable commodities (e.g. wheat) are inversely
related to the intensity of the economic activity and
provide inferior inflation hedging.
Commodity whose demand is related to Economic
activity: Theses commodities tend to provide good
hedge against unexpected changes in inflation.
Commodity whose demand is not related to economic
activity: These commodities tend to provide poor hedge
against unexpected changes in inflation.

NOTE: Commodities also provide opportunities for active
management that may involve short as well as long
positions.

Note: Mismatches in supply and demand exist only in
short term (Samuelson effect).
6.

Investors include:
•
•
•
•
•

Institutional investors
Corporate and public pension funds
Endowments
Trusts
Bank trust departments

Characteristics:
They are allowed to avoid certain reporting and other
requirements as well as some restrictions on incentive
fees.
Unlike traditional mutual funds, hedge funds are allowed
to take aggressive long or short positions and use high
leverage.
They do not perform relative to any specific
benchmark/index and seek to maximize absolute

returns.
Forms of hedge funds include:
i.
ii.
iii.

Limited partnership
Limited liability Corporation
Offshore corporation.

Note: Managed futures are now generally classified as
hedge funds.
6.1.1) Types of Hedge Fund Investments
Hedge funds are classified according to the following
investment styles.

HEDGE FUNDS

1) Equity Market Neutral: It involves identifying
undervalued and overvalued equities and neutralizing
the portfolio’s exposure to market risk (β = 0) through a
combination of long and short positions with roughly
equal exposure to the related market or sector factors.
• They have little or no market risk. However, hedges
may be imperfect.
• They have low credit risk due to low (net) leverage
resulting from long-short positions.
• Using this strategy, funds have no Correlation with
S&P 500.
2) Convertible Arbitrage: It involves exploiting mispricing

in convertible securities i.e. convertible bonds, warrants
and convertible preferred stock i.e. buying/selling
convertible bonds and hedging the equity component
of the bond’s risk by taking the opposite position in the
associated stock.
• Hedging risks results in decrease in market exposure.
• This strategy involves higher credit risk due to high
leverage exposure resulting from hedging via
derivatives.
• These strategies have low correlation with stocks
and bonds.
Risks include:
•
•
•
•

Changes in the price of the underlying stock
Changes in the expected volatility of the stock
Changes in the level of interest rates
Changes in the creditworthiness of the issuer


Reading 26

Alternative Investments Portfolio Management

Gains include:
• Coupon on underlying convertible bond
• Short rebate

• Rapid increase in expected volatility of the
underlying asset increases value of option portion of
bond.
• Improvement in the credit quality of the issuer
(depends on the hedge strategy)
3) Fixed-Income Arbitrage: It involves identifying
overvalued and undervalued fixed-income securities on
the basis of expectations of changes in the term
structure of interest rates or credit quality of the various
related issues or market sectors. Due to the combination
of long and short positions, they are neutralized against
market directional movements.

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due to extensive use of leverage via derivative
instruments.
• They have higher correlation with stocks and bonds
relative to other strategies.
8) Emerging markets: Refers to investing in emerging
and less mature markets. Due to restrictions on short
selling and lack of derivative markets, short sales are
difficult and most funds are long.
9) Fund of funds (FOF): FOF invests in a number of
underlying hedge funds (typically 10-30 hedge funds).
They are generally preferred to be entry-level
investments because they provide professional
management and facilitate investors to delegate
individual manager selection to the FOF manager.
Advantages:

4) Distressed Securities: These refer to securities of
companies that are in financial distress or near
bankruptcy. Distressed funds invest in the debt or equity
of companies experiencing financial or operational
difficulty.
• These securities typically trade at a substantial
discount compared to their fair value.
• Due to relative illiquidity of distressed debt & equity,
short sales are difficult and most funds are long.
• Low correlation with world stock and bond
investments.
• Strategy performs well when the economy is not
doing well.

• Facilitate diversification among hedge fund
managers and strategies,
• Access to different strategies and expertise,
• Shorten the due diligence process to a single
manager.
• Provide a more accurate prediction of future fund
returns than that provided by the more generic
indices.
• Provide greater liquidity due to no lock-up period
provisions and allow more frequent investor exits.
• FOFs can represent a better benchmark because
they are less affected by survivorship bias.
Disadvantages:

5) Merger Arbitrage (or Deal Arbitrage): This strategy

seeks to generate returns from corporate merger and
takeover activity and attempts to exploit the price
spread b/w current market prices of corporate securities
and their value after successful completion of a
takeover, merger, spin-off etc.
Rule: Buy the stock of a target company after a merger
announcement and short an appropriate amount of the
acquiring company’s stock.
6) Hedged Equity: It involves identifying overvalued and
undervalued equity securities. However, portfolios are
not structured as market neutral and may be
concentrated i.e. may have a net long exposure to the
equity market. Hedged equity makes up the largest
category of hedge funds in terms of asset size (AUM).
• Highly concentrated
• Net short or long position
7) Global Macro: It involves taking large positions in
financial and non-financial assets to exploit opportunities
of systematic (market) moves through trading in
currencies, futures and option contracts.
• They concentrate on major market trends rather
than changes in individual security prices.
• This strategy involves higher credit (leverage) risk

• They involve two layers of fees i.e. one to the hedge
fund manager and other to the manager of FOF,
• Exhibit lower performance (lower returns) relative to
hedge funds.
• Requires maintaining cash buffer to meet liquidity
needs that results in lower expected returns.

• They are affected by style classification and style
drift.
• They are more highly correlated with equities
relative to individual hedge funds and thus provide
less diversification benefits.
Strategies can also be classified into the following five
broad groups (in ascending order of risk involved):
1) Relative Value: Attempt to exploit mispricing in
related securities.
• Have no correlation with the market.
• Example: Equity market neutral, convertible
arbitrage and hedged equity.
2) Event Driven: Seeks to generate positive return by
exploiting opportunities created by corporate events
(i.e. merger, bankruptcies, liquidation, buy back, etc.).
• Not correlated with market.
• Example: Merger arbitrage, distressed securities.


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Alternative Investments Portfolio Management

is paid until the fund’s NAV > HWM. When NAV >
HWM,

3) Equity Hedge: Seeks to generate return by reducing
market risk (beta) and generating alpha.
• Long/short managers use fundamental analysis.
• Investment is done in long and short equity positions

with varying degrees of equity market exposure
and leverage.
4) Global asset allocators: Seek to generate return from
an extremely wide variety of trading strategies and asset
classes. They can take directional views (both long and
short) on global interest rate, currencies, commodities,
equity.
5) Short selling: Equity is shorted in expectation of
decline in market price.

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Incentive fee = (positive difference between ending
NAV and HWM NAV) × incentive fee %.
• The high NAV establishes a new HWM.
Rationale for HWM provision: It is used to ensure that the
hedge fund manager earns an incentive fee only once
for the same gain.
Hurdle rate: According to hurdle rate provision, no
incentive fee is paid to mangers until a specified
minimum rate of return is earned by investors.
Lock-up Period: It is a period prescribed by hedge funds
during which no part of investment can be withdrawn
(commonly 3-5 years). Afterwards, investments will be
redeemed to investors only within specified exit windows
e.g. quarterly after the lock-up period has ended.
Rationale for lock-up period: To protect managers from
unwinding positions during unfavorable circumstances.

Note: Both relative value and event driven are Market

Independent.
Five most popular hedge fund strategies include:
i.
ii.
iii.
iv.
v.

Equity market neutral
Hedged equity
Merger arbitrage
Convertible arbitrage
Global macro

For two similarly sized hedge funds following the same
strategy (all else equal), the fund that charges lower
management fee is expected to deliver superior
performance.
Hedge funds with superior past track records can obtain
higher than average incentive fees.
6.2

Benchmark and Historical Performance

6.2.1 Benchmarks: Hedge Funds benchmarks include
both monthly and daily series.
Monthly hedge fund indices include:

Compensation structure of Hedge Funds: It comprises of:
Management fee (or AUM fee) + Incentive fee

where,
Management fee= % of NAV (net asset value). It ranges
from 1-2%
Incentive fee= % of profits as specified by the terms of
the investment. Traditionally, it has been
20% but now is approximately 17.5%.
High Water Mark Provision (HWM):It requires that
incentive fees are only based on returns above the
highest value achieved over the life of the fund i.e. it
specifies NAV that a fund must exceed before
performance fees are paid to the hedge fund manager.
Rule:
• Once the first incentive fee has been paid, the
highest month end NAV establishes a high water
mark. If NAV then falls below HWM, no incentive fee

i.
ii.
iii.
iv.
v.

vi.

vii.

CISDM: Equally weighted
Credit Suisse/Tremont: Weights depend on AUM
EACM Advisors: Equally weighted composite of
100 hedge funds.

Hedge Fund Intelligence Ltd: Equally weighted
Hedge Fund.net (a.k.a. Tuna indices): Covers
more than 30 strategies and are equally
weighted.
HFR: Equally weighted hedge fund indices based
on managers reporting to the HFR database of
hedge fund returns.
MSCI: Indices are separated according to asset
class and geographical region

• Equally weighted
• However, at higher levels of aggregation both
equally weighted and asset-weighted versions are
available.
Daily Hedge Fund Indices include:
i.

Dow Jones Hedge Fund Strategy Benchmarks


Reading 26

ii.
iii.
iv.

Alternative Investments Portfolio Management

HFR hedge fund indices
MSCI hedge fund Index.

S&P hedge fund indices: Equally weighted and
are rebalanced annually.

Differences in the construction of the major managerbased hedge fund indices:
1) Selection criteria: Hedge funds are selected to be
included in the index according to different selection
criteria i.e. length of track record, AUM, and restrictions
on new investment.
2) Style Classification: Different approaches are used by
indices to categorize a hedge fund in a specific style
index and decision regarding exclusion or inclusion of
the fund from the index when it fails to satisfy style
classification.

sensitivities to market factors. Thus, volatility of
hedge fund based investment portfolios can be
reduced through diversification among hedge fund
strategies.
Liquid Alternatives (a.k.a. liquid alts): are variety of
hedge fund like investment strategies. Unlike hedge
funds, liquid alts
Unlike hedge funds, liquid alts:
•
•
•

•
•
•

• Equally weighted
• Dollar weighted on the basis of AUM
• Both

5) Investability: An index can be directly or indirectly
investable. Most of the monthly manager-based hedge
funds indices are not investable but most of the daily
hedge fund indices are investable (i.e. in case of FOFs).
Alpha Determination and Absolute Return Investing
Hedge funds focus on absolute returns and have no
direct benchmark portfolios. Therefore, it is difficult to
determine alpha in hedge funds. However, to determine
alpha in hedge funds, following two methods can be
used:
1)
2)

Single-factor or multi-factor methodology
Optimization to create tracking portfolios with
similar risk and return characteristics.

6.2.2 Historical Performance
• Historically, hedge funds have shown superior return
performance relative to other traditional asset
classes.
• They provide risk diversification benefits due to their
low correlations (<1) with traditional asset classes.
• Equity market neutral and fixed income arbitrage
have low correlations with stocks and bonds. Thus,
they can be considered risk diversifiers.

• Event driven and hedged equity have moderate
correlations with S&P 500. Thus, they can be
considered return enhancers instead of risk
diversifiers.
• Different hedge fund strategies have different

have attractive fee structures
provide daily liquidity and transparency.
are Accessible to wider range of investors

Some strategies followed by liquid alts are:

3) Weighting scheme: Different approaches are used by
indices to determine weights of fund’s returns in the
index. Common weighting methods include:

4) Rebalancing Scheme: Assets are reallocated
according to rebalancing rules e.g. monthly, annually
etc.

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•

Equity Long-Short: selects stocks based on topdown or bottom-up analysis and hedge
market exposure with short equity or long put.
Event Driven: equity or debt exposure in firms
involved in corporate events such as merger or
restructuring.
Relative Value: taking both long and short

position to benefit from mispriced stocks
between similar or related securities.
Macro: long or short positions in a variety of
asset classes based on macroeconomic
conditions.

6.2.3 Interpretation Issues: Performance of hedge fund
indices varies with given time period (particularly due to
different weighting schemes) which makes it difficult for
investors to select appropriate index. However,
comparable hedge fund indices have similar risk factor
exposures.
Reasons for low correlation between similar strategy
indices:
i.
ii.

Differences in size and age restrictions
Differences in weighting schemes

Biases in Hedge Fund Index Creation:
1) Popularity Bias: Refers to index biasness towards bestperforming or popular hedge funds in a particular time
period.
Cause: Indices that are value weighted may reflect
current popularity with investors because the asset
values of the various funds change as a result of asset
purchases and price.
Solution:
• Equally weighted indices can be used to better
reflect potential diversification of hedge funds.

However, these indices involve high rebalancing
costs and decrease Investability of the index.
• Custom or negotiated benchmarks can also be
used.


Reading 26

Alternative Investments Portfolio Management

2) Survivorship Bias: It results when managers with poor
track records exit the business and are dropped from the
database whereas managers with good records remain.
This bias is estimated to be in the range of 1.5 – 3% per
year. This bias results in:
• Overestimated historical returns.
• Understated volatility.
It varies among different hedge fund strategies i.e.
• It is minor in event-driven strategies.
• It is higher for hedged equity strategies.
• It is significantly higher in currency funds.
Solution: This bias can be reduced by:
• Conducting superior due diligence.
• Using FOFs
3) Stale Price Bias: This bias occurs due to lack of
security trading and use of stale prices. It results in:
• Low measured correlations than expected
• Higher/lower measured S.D than expected
(according to time period chosen)
Important Note: However, it is important to note that

stale price does not result in a significant bias in hedge
funds because of use of monthly data in hedge fund
indices creation and strategies based on liquid
underlying holdings.
4) Backfill Bias (Inclusion Bias): It results when the entire
return history of hedge funds is added to the index after
they have exhibited successful years. Like survivorship
bias, it results in overestimation of good results and
understated volatility.
Relevance of Past Data on Performance:
• Volatility of return is more persistent through time
than the level of returns. Therefore, future returns
are best forecasted by evaluating consistency of
volatility instead of returns.
• Past returns do not represent good predictors
because composition of hedge fund indices
changes over time. This problem is more severe in
value weighted indices than equally weighted
indices.
• Age effects make it difficult to compare the
performance of hedge funds that have track
records of different lengths.

6.3

Investment Characteristics and
Roles of Hedge Funds

Hedge funds are classified as skill based investment
strategies.

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Hedge funds returns are uncorrelated or weakly
correlated with long-term return of the traditional stock
and bond markets.
It should be taken into account that skill in producing
investment success depends on market opportunity e.g.
opportunities for merger arbitrage hedge funds
significantly depends on merger activities.
6.3.1 Investment Characteristics
Equity-market neutral and fixed-income arbitrage
strategies are less affected by market risk factors and
therefore, regarded more as diversifiers for traditional
stock and bond portfolios.
Long-bias equity based and fixed income based hedge
fund strategies are primarily affected by changes in
market risk factors and therefore are regarded less as
portfolio risk diversifiers and more as portfolio return
enhancers.
Multi-manager hedge fund portfolios (fund of funds)
may have risk levels similar to that of a larger population
of hedge funds.
6.3.2 Roles in the Portfolio
Diversification benefits of adding hedge funds in various
groups can be variable. Research shows, standard
deviation of randomly selected equally-weighted
portfolio of five to seven hedge funds is similar to the
population from which it is drawn.
Historical Performance

• Risk adjusted return improves (i.e. Sharpe ratio
increases) when hedge fund is added to a
traditional portfolio consisting of stocks and bonds.
• However, according to various studies, including
hedge funds can also frequently lead to lower
skewness and higher kurtosis. Note that investors
prefer positive skewness and moderate kurtosis.
NOTE:
• Distressed debt hedge funds are exposed to the risk
of increased credit spreads.
• Maintaining market neutrality involves dynamic
portfolio adjustments and thus in case of low
liquidity, cost of shorting equity markets increases.
Techniques to neutralize negative skewness in a
portfolio:
1. Smart hedge fund selection (i.e. combination of
different strategies) can help to reduce the problem
of negative skewness e.g. global macro funds have
tended to exhibit
• Positive skewness
• Moderate correlation with equities
• High kurtosis and volatility


Reading 26

Alternative Investments Portfolio Management

Equity market-neutral strategies tend to act as volatility
and kurtosis reducers.

2. Invest in managed futures because they tend to have
opposite skewness characteristics compared to many
hedge funds.
6.3.3 Other issues:
• Young funds outperform old funds on a total return
basis.
• On average, large funds underperform small funds.
• FOFs better reflect return estimation relative to
indices.
• Performance fees and lock-up impacts: Historically,
hedge funds with quarterly lock-ups have exhibited
higher returns than similar strategy funds with
monthly lock-ups.
• Vintage (age) effects: Because of vintage effects, it
is difficult to compare the performance of funds
with different lengths of track record.
Hedge fund due diligence: Investment risk in hedge
funds is attributed to the following reasons.

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Conventions followed by Hedge Funds for treatment of
leverage: In hedge funds, the convention is to treat the
leverage as if the asset were fully paid i.e. return on
levered position is based on:
Amount actually paid + funds borrowed
• This implies that leverage only affects the weighting
of an asset in the portfolio and not the return on the
individual asset.
Similarly, the principle of deleveraging is used to

compute the rate of return when derivatives are
included in the hedge fund portfolio.
The rolling return (RR): It is the moving average of the
holding-period returns for a specified period equal to the
investor’s time horizon i.e.
RR n,t = (Rt + Rt-1 + Rt-2 + … + R t –(n-1) / n
e.g. if investor’s time horizon is 12 months, the rolling
return would be:
RR 12,t = (Rt + Rt-1 + Rt-2 + … + R t –11 / 12

• Hedge funds are loosely regulated.
• Do not have any mandated and standardized
disclosure requirements.
• Annual audited financial statement (may be
provided) but no disclosure exists regarding existing
portfolio positions.
• Non-transparent operations and/or strategies.
Thus, in order to reduce investment risk, investing in
hedge funds requires high due diligence.
Due diligence is based on the same framework as
described in Example 2 of this Reading
Practice: Example 2 & 13,
Volume 5, Reading 26.

6.4

Uses of RR:
• Provide insight into the characteristics and qualities
of returns.
• Shows consistency of returns over investment period

and identify any cyclicality in the returns.

Volatility and Downside Volatility
Hedge funds returns have non-normal distribution.
Therefore, S.D. (used as a risk measure) incorrectly
represents the actual risk of a hedge fund’s strategies.
Thus, following measures can be utilized.
Downside Deviation or Semi-deviation:
۲‫ ܖܗܑܜ܉ܑܞ܍܌܍܌ܑܛܖܟܗ‬ൌ ඨ

Performance Evaluation Concerns

In reviewing the performance of a hedge fund, following
factors must be considered by investors:
Returns:
Rate of return = [(Ending value of portfolio) – (Beginning
value of portfolio)] / (Beginning value of
portfolio)
• These returns are typically compounded over 12
months periods or 4 periods in case of quarterly
data to obtain the annualized rate of return.
• The reporting and compounding frequency can
significantly affect hedge fund’s apparent
performance.

∑௡௜ୀଵሾ݉݅݊ሺ‫ݎ‬௧ െ ‫ ∗ ݎ‬, 0ሻሿଶ
݊െ1

where,
r* = threshold i.e. can be 0 or prevailing short term rate or

any rate selected by user.
‫ ܖܗܑܜ܉ܑܞ܍܌ –ܑܕ܍܁‬ൌ ඨ

∑௡௜ୀଵሾ݉݅݊ሺ‫ݎ‬௧ െ ݉‫݊ݎݑݐ݁ݎݕ݈݄ݐ݊݋‬, 0ሻሿଶ
݊െ1

Advantages:
• It does not penalize high positive returns like S.D.
• It helps to distinguish between good and bad
volatility.


Reading 26

Alternative Investments Portfolio Management

Drawdown: In hedge funds, it is the difference between
a portfolio’s point of maximum NAV (i.e. high HWM) and
any subsequent low point (until new “high water” is
reached).
Maximum Drawdown: It is the largest difference
between a high-water point and a subsequent low NAV.
A portfolio appears to be in a position of drawdown from
a decline from a high water mark until a new high water
mark is reached. In order to evaluate hedge fund
performance, it is important to analyze the record of
recovering from losses and length of period to be in
drawdown position.
Performance Appraisal Measures
Sharp ratio: It measures the average amount of return

greater than the risk-free rate per unit of risk (i.e. S.D of
return).
Sharpe ratio = (Annualized rate of return – Annualized
risk-free rate*) / Annualized S.D.
* One -year T-bill yield
Limitations of Sharpe Ratio:
1.

It is time dependent i.e. annual Sharpe ratio will be
√12 greater than a monthly Sharpe ratio if returns
are serially uncorrelated.
It is not an appropriate measure of risk-adjusted
performance when returns have asymmetrical
distribution.
It is biased upwards when there are illiquid holdings.
When returns are serially correlated, S.D is
underestimated and Sharp ratio is overestimated.
This problem exists due to stale pricing or illiquidity
(e.g. distressed securities).
It is a risk-adjusted performance measure for “standalone” investments and does not incorporate
correlations with other assets in a portfolio.
It does not have a predictive power for hedge
funds.
It can be manipulated (i.e. artificially increased) by
managers in the following ways:

2.

3.
4.

5.

6.
7.

i.

ii.

iii.

iv.

v.

Lengthening the measurement interval: The
greater the measurement interval, the lower the
S.D and the lower the estimated volatility (i.e.
annualized S.D of daily returns > weekly).
Using the compounded monthly returns but S.D.
calculated from non-compounded monthly
returns.
Writing out-of-money puts and calls on a portfolio:
This involves earning the option premium without
paying off for several years. It results in overstated
Sharpe ratio.
Smoothing of returns: Infrequent marking to market
of illiquid assets and understatement of monthly
gains and losses can understate the reported

volatility.
Getting rid of extreme returns (best and worst
monthly returns each year): This can be achieved

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by using total return swap i.e. one pays the best
and worst returns for one’s benchmark index each
year and the counterparty pays a fixed cash flow
and hedges the risk in the open market. Options
can also be used when swaps are not available.
Sortino Ratio:
= (Annualized rate of return – Annualized risk-free rate*) /
Downside Deviation
* Minimum acceptable return or risk free rate is typically
used.
Gain-to-loss Ratio: It measures ratio of positive returns to
negative returns over a specified period of time. The
higher the ratio, the better it is.
ൌ൬

numberofmonthswithpositivereturns
൰
numberofmonthswithnegativereturns
averageup െ monthreturn
ൈ൬
൰
averagedownmonthreturn

Calmar ratio = Compound Annualized ROR / ABS*

(Maximum Drawdown)
Sterling ratio=

Compound Annualized ROR / ABS*
(Average Drawdown - 10%)
Correlations: They are used to evaluate
portfolio diversification and are only
appropriate to use for normally
distributed returns.

where,
*ABS = Absolute Value
Skewness: Skewness is a measure of asymmetry in the
distribution of returns. Symmetrical distribution has zero
skewness. Investors prefer positive skewness.
Kurtosis: Kurtosis evaluates how close or far from the
mean, returns are clustering. Investors prefer low kurtosis.
Consistency: Consistency analysis is primarily useful when
funds of the same style or strategy are compared. It is
important to analyze the number of months that the
strategy has had positive (or negative) returns, the
number of months that the strategy has had positive (or
negative) returns when the market is up (down), and the
average monthly returns in up and down markets.
• Investors prefer that a fund should have a greater
% of positive returns and less negative than the
benchmark in all market conditions.

Practice: Exhibit 27 & 28,
Volume 5, Reading 26.

Reading 26

Alternative Investments Portfolio Management

7.

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MANAGED FUTURES

Managed futures are private pooled investment vehicles
that invest in cash, spot and derivative markets.
Characteristics:

Classification of managed futures:
Investment style e.g. Systematic or discretionary
Markets traded e.g. currency or financial
Trading strategy e.g. trend following or contrarian

1)
2)
3)

Able to use leverage in a variety of trading strategies.
Generally structured as limited partnerships that is
available only to institutions and high-net-worth
individuals.
Managed futures are generally viewed as a subset of

global macro hedge funds.
Like hedge funds, managed futures are classified as skill
based investment strategies.

• Trend following strategy provides less
diversification relative to contrarian strategy.
Trading Strategies:
1.

Systematic Trading Strategies: Refer to rule-based
trading strategies which are frequently trend
following.

2.

Discretionary trading strategies Refer to trading
strategies based on portfolio manager judgment
rather than rules. It involves use of fundamental
economic data and trader beliefs.

Like hedge funds, they are described as absolute return
strategies.
• Available both as private commodity pools and
separately managed accounts.
• Publicly traded commodity funds for small investors
are also available.
• Compensation arrangements are similar to that of
hedge funds i.e.
• Compensation structure: management fee +
incentive fee. Commonly it is 2% + 20%.

Comparison
Managed Futures

Hedge Funds

Trade exclusively in
derivative markets

Mostly trade in spot
markets and use
derivatives for hedging.

Tend to focus on return
opportunities in macro
(index) stock

Trade in individual
securities i.e. tends to
focus on micro (security)
stock and bond
markets.

Highly regulated relative
to hedge funds.

Loosely regulated.

7.1

Managed Futures Market

Managed futures strategies are based on the use of
professional money managers.

On the basis of markets, managed futures have the
following classification:
1.

Financial i.e. financial futures/options, currency
futures/options and forward contracts.
2. Currency i.e. currency futures/options and forward
contracts.
• Diversified i.e. financial futures/options, currency
futures/options and forward contracts as well as
physical commodity futures/options.
Size of the Managed Futures Market: According to AUM,
managed Futures industry is probably approximately<
10% the size of the hedge fund industry.
7.2

Benchmarks and Historical Performance

The benchmarks for managed futures are similar to those
for hedge funds.
1) Mount Lucas Management Index (MLMI):
• It is an investable benchmark for actively managed
derivative strategies.
• It takes both long and short positions in a number of
futures markets based on a technical (moving
average) trading rule.

2) Dollar weighted CISDM CTA$ benchmarks
3) Equal weighted CISDM CTEQ benchmarks.

General partners in managed futures are known as
commodity pool operators (CPOs).

Bias: Benchmarks for managed futures require special
weighting system.

Professional commodity trading advisors (CTAs)are hired
by CPOs to manage money in the pool.

Historical performance

Both CPOs and CTAs are registered with the U.S.
Commodity Futures Trading Commission and National
Futures Association (self-regulatory body).

• CISDM CTA$ exhibited higher Sharpe ratio relative
to equities but not relative to bonds.
• CISDM CTA$ has slightly negative correlation with
equity indices.


Reading 26

Alternative Investments Portfolio Management

• CISDM CTA$ has similar correlations with U.S. and
global bonds i.e. 0.42 and 0.46 respectively.

• The overall dollar-weighted and equal-weighted
indices have high correlation with diversified,
financial, and trend following strategies and low
correlation with currency and discretionary
strategies.
• Across CTA strategies, they have low correlation
with U.S. equities and low to moderate correlation
with U.S. bonds.

7.3

Managed Futures: Investment Characteristics
and Roles

Investment characteristics:
Derivatives markets are zero-sum games. This implies that
the long-term return to a passively managed, unlevered
futures position should equal to the risk-free return on
invested capital less management fees and transaction
costs. In order to produce positive excess returns (on
average), there must be a sufficient number of hedgers
(who pay risk premium to liquidity providers) or other
users of the derivative markets who systematically earn
lower than the risk-free rate.
CTAs are not restricted to exploit arbitrage opportunities.
Mostly, momentum strategies are followed by actively
managed derivative strategies. Momentum trading
tends to provide useful information regarding positive
skewness to managed future returns.
It is easier to take short positions in futures; thus, it is

possible to earn positive excess returns in falling as well
as rising markets.
Managed futures facilitate investors to employ strategies
available in a cash market at a lower cost.
Managed futures also provide strategies that are not
available to cash investors.

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Roles in the Portfolio:
Provides diversification benefits because they have low
and/or negative correlations with traditional asset class.
They provide better risk-adjusted performance.
Managed futures help to optimally allocate investment
capital i.e. when stocks and bonds underperform due to
rising inflation concerns, certain managed futures may
outperform in such conditions.
Important:
• Managed futures appear to have negative
correlation with traditional investment vehicles
when cash markets incur significant negative
returns.
• Managed futures appear to have positive
correlation with traditional investment vehicles
when cash markets incur significant positive
returns.
Sharpe ratio increases when they are added to
traditional portfolio.
Other issues:
• Past CTA performance can be reliably used to

forecast CTA and multi-advisor CTA portfolio’s return
and risk parameters (particularly at portfolio level).
• Because of the use of derivatives and leverage like
in hedge funds, they require similar due diligence as
that of hedge funds. In addition, significant
attention should be paid to the risk management
practices of CTA.

Practice: Example 14,
Volume 5, Reading 26.

They facilitate investors to gain exposure to unique
sources of return and thus provide diversification
benefits.
8.

DISTRESSED SECURITIES

Distressed Securities are the securities of companies that
are in financial distress or near bankruptcy. In U.S.,
investing in distressed securities involves:
• Purchasing the claims of companies that have
already filed for Chapter 11* (protection for
reorganization) or
• Purchasing the claims of companies that are
expected to file for Chapter 11 in near future.
*Under chapter 11 protection, companies try to avoid
chapter 7 (i.e. protection against liquidation) through an
out-of-court restructuring of debt with their creditors.

• Opportunities for managers exist due to the
following reasons:
o Relatively under-researched by analysts
o Many investors are unable to hold belowinvestment-grade securities

8.1

Distressed Securities Market

The market opportunities for distressed securities strategy


Reading 26

Alternative Investments Portfolio Management

• Increase with the increase in default rates on
speculative grade bonds and
• Decrease with the increase in the number of
distressed debt investors seeking to exploit
mispricing in such securities.
8.1.1) Types of Distressed Securities Investments
There are two major structures through which investors
can access distressed securities investing:
1. Hedge fund structure: It is considered to be the
dominant type.
Advantages
• Facilitate to take in new capital on a continuing
basis.
• AUM fee and incentive structure (particularly when

there is no hurdle rate) is more profitable relative to
other structures.
• Provide more liquidity to investors (i.e. can withdraw
capital more easily).
2.

Private equity fund structure: They have a fixed term
and are closed-end.

Advantage
• Preferable to use when assets are illiquid or difficult
to value.
Other structures include:

Bias: Popularity bias, survivorship bias, backfill bias, selfreporting bias.
8.2.2) Historical Performance
Distressed securities exhibit non-normal distribution of
returns (particularly negative skewness and high kurtosis).
Thus, they are affected by downside bias. Therefore, it is
not appropriate to use Sharpe ratio as a risk-adjusted
performance measure.
Characteristics:
•
High Sharpe ratio
•
High mean returns
• Low S.D.; however, due to negatively skewed
distribution, risk measured by S.D is understated.
• Low correlation with traditional portfolio which
leads to higher return and lower risk.

• Performance is largely dependent on business
cycle and economic activity i.e.
o When economy performs weakly →
bankruptcies increase → strategy is profitable.
• Success of strategy also depends on the ability to
accurately predict whether an event will occur or
not (i.e. event risk).
Note: It is not necessary that all non-investment-grade or
high-yield bonds are distressed securities.
Strategies of investing in Distressed Securities
1.

• Hybrid structures consisting of both hedge fund and
private equity.
• Separately managed accounts
• Open end investment companies (mutual funds)
Types of assets in which distressed securities managers
invest in include:
1.
2.

3.
4.
5.

2.

Distressed Debt Arbitrage: It involves buying the
traded bonds of bankrupt companies (at large
discounts) and selling the common equity short. This

approach is commonly used by Hedge Funds.
• When the company’s prospects improve: value of
company’s debt and equity increases but the debt
is expected to appreciate more in value relative to
equity due to senior claim enjoyed by bonds.
• When the company’s prospects worsen: value of
company’s debt and equity decreases but the
equity (in which manager has short position) is
expected to decline more in value relative to debt.

8.2.1) Benchmarks

Construction: Either equally-weighted or AUM weighting
system is used.

Long-only Value Investing: It involves investing in
perceived undervalued distressed securities in
expectation of an increase in its value.
• When the distressed securities are public debt, it is
known as high-yield investing.
• When the distressed securities are orphan equities, it
is known as Orphan equities investing.

Publicly traded debt and equity securities of the
distressed company
Orphan equity: It refers to investing in a newly
issued equity of an undervalued company (after
reorganization).
Bank debt and trade claims
‘Lender of last resort’ notes

Different derivative instruments for hedging
purposes i.e. CDS.

Distressed securities (from hedge funds perspective) are
often classified as a sub-style of event-driven strategies.
All major hedge fund indices (i.e. EACM, CISDM and
HFR) have sub-indices for distressed securities.

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3.

Private equity: It involves an active-value approach.

Active-value approach: The objective of active
involvement is to increase the value of the distressed
company by utilizing the company’s assets more
efficiently. Active approach involves
proactively/aggressively protecting and increasing the
value of their claims.


Reading 26

Alternative Investments Portfolio Management

Relative-value approach: In this approach, passive
investors buy distressed securities to either hold them in
expectation of value appreciation or trade them with
relatively short period of time.

A variation of active-value approach is Prepackaged
Bankruptcy in which distressed debt is converted into
private equity. In this approach:
• The firm takes a dominant position in the distressed
debt of a public company.
• Afterwards, firm seeks to become the majority
owner of a private company on favorable terms.
• When company’s prospects improve afterwards,
company can be sold to private or public investors.
Investors exhibiting this Private equity approach are
known as “Vulture” investors; and their funds are called
“vulture funds” or “Vulture capital”.
Effects of outcomes of prepackaged bankruptcy on
the various parties involved:
a) Pre-bankruptcy Creditors of the company:
Creditors agree in advance with the Debtor Company
regarding the plan or reorganization before bankruptcy
has been filed and make concessions in return for equity
of the reorganized company.
b) Pre-bankruptcy Shareholders of the company:
These shareholders have less leverage relative to
creditors and they typically lose their entire stake in the
company as the vulture investor (private equity firm)
seeks to become a majority owner of the new private
equity.
c) Vulture Investors:
The vulture investor bears a lot of risk and when the
company’s prospects improve afterwards, company
can be sold to private or public investors.
8.3.1) Investment Characteristics of Distressed Securities

• Potential of high returns from exploiting mispricing
i.e. security selection.
• Sources of investment opportunities include:
a) Fallen Angels: Securities that are downgraded
from investment grade to high-yield. These are
different from originally ‘high-yield’ securities (i.e.
securities issued by firms with high risk profile and
existing senior debt).
b) Failed leveraged buyouts
• It requires access to specialist skills and experience
in credit analysis and business valuation.
• Both potential outcomes of the company as a
going concern and liquidation value need to be
assessed.
• It requires evaluation of the sources of the

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company’s problems, core business & financing
structure.
• Investing in distressed securities requires legal,
operational and financial analysis.
• The strategy is based on “company selection”
because each distressed situation has a unique
approach and solution.
Distressed Securities are suitable for investors with:
• High risk tolerance
• Long time horizon
NOTE:
Distressed securities are not riskier than traditional asset

classes in all respects.
During recession, there are more bankruptcies that result
in increase in the supply of distressed securities and thus
decrease in their prices. Therefore, it represents a good
time to invest in distressed securities when the economy
faces recession.
Risks associated with Private Equity Investing:
1) Event Risk: Event risk is associated with companyspecific or situation-specific risks and thus has low
correlation with the general stock market. It is
considered a major risk in distressed securities investing.
2) Market Liquidity Risk: Distressed securities have
relatively low liquidity and market liquidity is largely
determined by demand and supply for securities that
can be highly cyclical in nature. This is a major risk in
distressed securities investing.
3) Market Risk: Market risk is associated with economy,
interest rates and state of equity markets. This is not
considered a major risk in distressed securities investing.
4) J Factor Risk: J-factor risk refers to the risk investors in
distressed debt face from judicial decisions.
Other risks include:
• Lack of information about other investors.
• Risks associated with legal proceedings i.e.
uncertain nature of the outcome of legal
proceedings makes analysis of such investment a
challenging task and requires extensive due
diligence.
• Distressed securities are nonmarketable at the time
of purchase.
• It is difficult to value holdings in distressed securities

because strategy outcomes are based on long
time horizon.
• Difficult to estimate true market value of securities
which consequently results in stale pricing. In case
of stale valuations, risk of this strategy is understated
and Sharpe ratio is overstated.
• Its return distribution is not normally distributed i.e.
has negative skewness and positive kurtosis.


Reading 26

Practice: Example 16,
Volume 5, Reading 26.

Practice: End of Chapter Reading
Problems for Reading 26 & FinQuiz
Item-set ID# 10239, 10243 & 13008.

Alternative Investments Portfolio Management

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