FinQuiz smart summary,alternative investment portforlio management

Investment Universe Modern Alternative Investments Distressed Securities Traditional Alternative Investments Exposure to specialized investment strategies hedge funds & managed futures

“ ALTERNATIVE INVESTMENTS PORTFOLIO MANAGEMENT ”

2 ALTERNATIVE INVESTMENTS: DEFINITIONS, SIMILARITIES, AND CONTRASTS

characteristics that differ markedly from those of traditional stocks & bonds investments

Features of alternative investments:

Illiquidity (require liquidity premiums)

Diversification (relative to stocks & bonds)

Higher due diligence costs (complex securities)

Performance appraisal is difficult

Less informational efficiency (greater scope for active management)

Investment Universe

Modern Alternative Investments

Distressed Securities

Traditional Alternative Investments

Exposure to specialized investment strategies (hedge funds & managed futures)

Investments that combine features of prior two groups (private equity & distressed securities)

Illiquidity of AI is a major concern for short term investors

AI are not suitable for smaller portfolios due to
due diligence costs

Active Manager Selection Process

AM = Arithmetic Mean

GM = Geometric Mean

CY = Convenience Yield HWM = High Water Mark MVO = Mean Varian Optimization

SD = Standard Deviation

DD = Downside Deviation

Active Manager Selection Process

Organization

Is the firm well organized & stable?

Compensation, turnover & succession plan

People

Consider trustworthiness of people

Speak at length of principal face to face

Reference checks

Terms & Structure

Check whether fund or account structured appropriately to the opportunity

Distinct emotional & financial needs

Communication with Client

Advisor face communication problem (complex investment, non professional investor)

3 REAL ESTATE

3.1 The Real Estate Market

Our focus is equity investment in real estate

Potential return enhancement & risk diversification benefit

3.1.1 Types of Real Estate Investments

Companies holding RE ownership, development or management

According to GICS & FTSE industry classification benchmarks

Publicly traded equities representing RE properties & /

Investments in RE can be open-end

& closed-end CREFs funds

Closed end funds use leverage &

have
return objectives

Separately Managed Accounts

Often offered by the CREFs sponsoring advisors

Important alternative to CREFs

3.1.2 Size of the Real Estate Market

RE represents one third to one half of the world’s wealth (figures are hard

to documents)

3.2.1 Benchmarks

To measure performance of direct real estate

Quarterly benchmark for RE (sample of commercial properties)

Value weighted index

Subsidies by RE sectors & geographical region

Property appraisal determines values in the index (conducted infrequently & remain unchanged)

Index is smoothed & underestimates volatility &

correlation

Methods developed to unsmooth the index

Benchmark for indirect investments in RE

Market-cap-weighted index of all REITS (real time)

NAREIT also computes monthly

Equity REITs index

Mortgage REITs index

Hybrid REITs index

Significant measurement issues are associated with direct & indirect investments

3.2.2 Historical Performance

Over the period of 1990-2004, both direct & indirect RE investments produced better risk adjusted performance than traditional investments

NAREITs index hedged = long on equity REITS index & short on equity index

NCREIF index represents non-leveraged investments & representative of the performance of private RE funds

Direct & securitized RE investment performance differ significantly

3.2.3 Interpretation Issues

NCREIF is not an investable index (performance appraisal is difficult)

3.3 Real Estate: Investment Characteristics and Roles

In a strategic asset allocation, advisors don’t include client’s residencies as marketable assets

3.3.1 Investment Characteristics

RE is an asset (have intrinsic value) & holds a substantial income component (commercial RE)

Characteristics of physical RE market:

Illiquid & large lot sizes

High transaction costs

Heterogeneity & immobility

Low information transparency (better risk adjusted returns for efficient, high quality information investors)

Demographics, market, economic & idiosyncratic factors affect RE

Complete RE diversification can be achieved only by investing internationally

Direct Equity RE Investing

Tax subsidies

More financial leverage

Direct control over property

Geographical diversifications reduce catastrophic risks (e.g risk of

floods)

On average, RE returns are less volatile than returns to equities

Not easy to divide into small pieces & may involve large idiosyncratic risk

Cost of acquiring information is

High commissions & substantial operating & maintenance costs

Risk of neighborhood deterioration

Income tax benefits may be subject to political risk

3.3.2 Roles in the Portfolio

RE markets follow economic cycles

economic cycles results in improved dynamic strategies

The Role of Real Estate as a Diversifier

Add value through active management

Low correlation with stocks & bonds

REITS provide some diversification benefits relative to traditional investments portfolio but no benefits to a portfolio consisting stocks, bonds, hedge funds & commodities

Direct RE investment provides more diversification benefits than indirect investments

Diversification within Real Estate Itself

Different RE sectors differ with reference to risk & return

Apartment sector of commercial RE yielded better results than simply diversifying across all sectors

Direct RE investment may provide inflation hedge to some degree

Direct market exhibits a high degree of return persistence

Investment in Real Estate Worldwide

Investors may benefit from including domestic & international investments in RE in their portfolios

3.3.3 Other Issues

Investment specific points (e.g valuation methods, tax issues etc) should also be considered in addition to due diligence process discussed previously

4 PRIVATE EQUITY AND VENTURE CAPITAL

PE ⇒ security by which equity capital is raised via private placement rather than through public offering

PE investments can be made directly (face to face) or through PE funds

Fields of PE

Investment in a risky company that starts out as private & may eventually become publicly owned

Taking a publicly owned company private

Private purchase of a division of public company

Buyout of private companies

Large investments in a public company usually at a price less than the current MV

product/services & entrepreneurial &/or managerial skills

PE investment involves distinct knowledge & experience (particularly direct P/E investments)

4.1 The Private Equity Market

Why market opportunities arise in VC investments:

To meet capital needs

Lack of managerial skills & experience

Diversification of wealth

Demand Supply

newly to young companies

young to established companies (preparing for IPO)

Seed & early stage investors

Relatively small but risky investment

vehicles

Venture Capital

companies’ investment in promising young companies in the same or related industry

funds if company has

exhausted its seed & start up

financing

Fund for
sales (generally for promising companies)

Exit from PE is often difficult

& in following ways

with small revenues & profits

finance a special dividend to owners

4.1.1 Types of Private Equity Investment

Investment through VC & buyout funds

Structured as convertible preferred stock rather than common stock

Shares of later rounds of financing are more valuable than earlier round shares

PE Fund Structure

Run by the GP (may be an individual or corporation)

GP also commits its own capital (better alignment of interests)

Hybrid of corporate & partnership form

Preferred form when raising funds from small group of knowledgeable investors

Run by managing director

Fund Manager Compensation

Often in the range of 1.5% - 2.5%

Usually a % of limited partners’ commitments

to the fund

Fund manager’s share of fund’s profit

Sometimes carried interest is paid only if profit exceeds hurdle rate

return money to investors if investors have not received their capital & share of profit

4.1.2 Size of the Private Equity Market

As of early 2006, approximately 200 billion U.S $ was invested in

PE VC & buyout funds worldwide

4.2 Benchmarks and Historical Performance

Infrequent market pricing of PE poses a challenge to index construction

IRR is used to measure performance of PE investment

4.2.3 Interpretation Issues

IRR calculation based on appraised value may

Use stale data (slow to adjust new circumstances)

Focus on company-specific events

Have no generally accepted standards for appraisals

Erroneous returns (due to all above factors)

4.3 Private Equity: Investment Characteristics and Roles

PE plays a growth role in portfolios

Investment via buyout funds involves less risk & earlier returns

4.3.1 Investment Characteristics

Investment characteristics of PE

Illiquidity ⇒ PE investments are illiquid & convertible PS investments don’t trade in

a secondary market

Long-term commitments required

Higher risk than seasoned public equity investments

High expected IRR required (for the risk & illiquidity)

Limited information (in case of VC investments)

Difference b/w VC & buyout funds

Buyout funds use more leverage than VC funds

CFs to buyout fund investors come earlier & often steadier than those to VC fund investors

VC fund investors are subject to greater error in return measurement

4.3.2 Roles in the Portfolio

Moderately high average correlation b/w private & public equity returns has an economic explanation (some economic & industry exposure in both)

PE has more company specific risk, so correlation is not extremely

Issues that must be considered when investing in PE:

Sufficient diversification

Liquidity of the position

Cash requirement for future capital calls

Appropriate diversification strategy

Indirect PE investment in secondary market can be made through purchase from limited partners seeking liquidity

4.3.3 Other Issues

Due diligence includes:

Managers experience, capabilities & commitment

Fund’s GIPS compliance

Fund selection is largely dependent on capabilities

of general manager’s management team

Evaluation of Prospects for Market Success

Markets, competition & sales prospects

Examination of financial statements

Potential for dilution of interest

Due Diligence

5 COMMODITY INVESTMENTS

nature (standardized futures contracts available)

Investment in commodities via cash & the derivatives markets constitutes alternative investing

5.1 The Commodity Market

Direct commodity exposure through:

Cash market

Future/forward/option market

To transfer commodity risk

To improve the functioning of spot &

forward markets

Commodity futures may be cash or delivery settled

5.1.1 Types of Commodity Investments

Purchase of commodity in cash or derivative market

Indirect claims on commodities (e.g investment

in companies specialized in commodity production)

Poor commodity exposure if commodity linked companies hedges their commodity exposure

Small investors can take commodity exposure through mutual funds & ETFs

5.1.2 Size of the Commodity Market

Commodity futures were estimated at U.S $

350 billion as of the 4th

quarter of 2005 (in U.S only)

5.2 Benchmarks and Historical Performance

Performance evaluation of commodity investments⇒ through commodity indices

5.2.1 Benchmarks

Long position on commodities & long futures produce similar return if futures are fully margined

Major commodity indices contain different groups of underlying assets e.g energy, metals etc

Market-cap weighting scheme is not suitable for commodity futures indices (every long futures position has a corresponding short position)

AM or GM to calculate index return from the component return

Two version of indices:

5.2.2 Historical Performance

Different commodity indices produce different results due to difference in composition & weights

Correlation of commodity indices with traditional asset classes is low (risk diversification benefit)

GSCI sector sub-indices indicate considerable risk & return difference among them

Recent Performance (2000-2004)

Commodity indices outperformed U.S & world

Commodity Index Return Components

Collateral Return

∆ in spot price of the underlying commodity

over a specified time period

Risk free return from the assumption that futures contract is 100% margined

Yield arises from rolling long futures positions

Monthly roll return= ∆ in future price over the month - ∆ in spot price over the month

Closer the futures contract to maturity &

the CY,
roll yield

5.3 Commodities: Investment Characteristics and Roles

To take passive commodity exposure ⇒ futures index investment ⇒ index should be liquid

5.3.1 Investment Characteristics

Commodities:

Are used to manage portfolio risk

Provide inflation hedge

Special Risk Characteristics

During financial & economic crisis, commodity prices tend to
(provide diversification benefits)

Determinants of commodity returns:

Economic cycle-related demand & supply

Convenience yield

Real options under uncertainty

Reasons for including commodity in a portfolio:

Related to economic fundamentals

Provide inflation hedge

Commodities as an Inflation Hedge

Storable commodities (e.g energy) have superior inflation hedging properties

5.3.2 Roles in the Portfolio

Commodities are considered as portfolio risk diversifier & provide inflation hedge

Investors with liabilities indexed to inflation, commodities provide better risk-return trade-off

Irrespective of passive long-only commodity exposures, commodities also offer potential for active management (both, long & short position)

Commodity active management can be done through separately managed account or private commodity pool

6 HEDGE FUNDS

HF are loosely regulated pooled investment vehicles with no universally accepted definition

Each HF strategy is used to exploit certain market opportunities

6.1 The Hedge Fund Market

As no of similar strategy HF
, their return

HF are absolute return vehicles, but some institutional investors require relative performance evaluation

6.1.1 Types of Hedge Fund Investments

Equity Market Neutral

Identify overvalued & undervalued equity

securities

Neutralize portfolio’s exposure to market risk

(through long & short positions)

Convertible Arbitrage

Exploit price anomalies in corporate convertible securities

Examples ⇒ buying the convertible bond &

shorting the associated stock

Fixed Income Arbitrage

Through identifying misvalued securities

Credit quality or term structures of IR are key