CFALevel III - Book - AlternativeInvestments Study online at quizlet.com/_orrm7 Meta Types Relative Value - Exploit Price Discrepancies Event Driven - Distressed Debt or Merger Arb Equity Hedge - L/S w/ net long short bets Global Asset Alloc - L/S Short Selling - Short Only AI Classes Commodities Direct- Buying the goods or futures - More Exposure/Carrying Costs Indirect - Owning a mining company More convenient , but might have little correlation to actual commodity Direct is more common AI Classes Private Equity Venture Cap - New Companies Buyout funds - Buy public companies and go private Middle Market - Buys divisions that are spun off Mega-Cap - Buys whole firms Process: Restructure Ops & mgmt., buy companies below intrinsic value, restructure debt or leverage company Dividend Recap - Private company issues debt and pays a large special dividend Recaps leverage company, keep % ownership and extract cash -Less of a diversifier more of a return enhancer -Requires high IRR - PE Returns tend to move w/ the markets, w/ some unsystematic risk in each deal VC and Buyout underperformed in 02-05 AI Classes Real Estate Direct - Owning the actual R.E Indirect - Investing in managed properties Pros: Low Corr w/ stocks/bonds Provides diversification - Each investment has unsystematic risk Direct investment provides more Diversification then REITS Low Volatility of return - high risk adjusted return is possible due to low liquidity, large lot sizes Inflation Hedge Tax advantaged Cons: High Info & Transaction Costs Political Risk (Tax laws) Inability to subdivide direct investment Benchmark Issues Selection Criteria: Size, Length, Track Record Style Class : Fairly Subjective Weighting: By size or equal weight Rebalancing Rules ? Investability - Depends on reporting Biases/Issues w/ BMs Relevance of past data - Indices turn over funds No consistency between style mangers volatility of returns tends to stay constant, but returns not! Popularity Bias - If a fund gets bigger then more weight in a value index Equal weight indexes are not effectively rebalanced Survivorship Bias - Indices drop failed funds/underperformers Backfill Bias - Filling in past/missing data Only managers that benefit will provide the data Many investible indices are available - Which is indicative or benefits of Derivatives! Pros: Fairly liquid * Low Correlation to stocks *Positively corr to inflation (except commodities) Energy has best returns Higher std deviation then S&P Still beneficial to sharpe ratio due to correlation! AI Classes Distressed Securities Skill based Either a hedge fund structure or private equity Negative Skewness (High Average Return) Uncorrelated Risk adjusted performance outperforms stocks and bonds AI Classes Managed Futures Typically Structured like a hedge fund, 2% fee plus 20% of profits over HW mark Skill based return not asset based Strategies - Trend following rules Contrarian Rules Total Discretion Typically financial markets or currency markets Risk: Varies by strategy Low/- correlation to Stocks Low Corr to bonds Similar return to stocks w/ less risk Higher return then bonds, but lower Sharpe 9 Commodities & Inflation Storability Demand relative to economic activity Storable - Metals, energy - move w/ inflation provide good diversification w/ exp inflation Non Storable - Agriculture - Not a good hedge Level Demand (Agric) - Bad Hedge Economic Demand (gold) - Good hedge 10 Daily Indices HFR DJ & S&P both list funds that are included equal weight 11 Distressed Debt Long Only - HY Bonds and Orphaned Equities Dist Debt Arb - Buy Debt and short stock P.E Buy a position in a company large enough to have control "Vulture Funds" Concerns Event Risk - Unsystematic Liquidity - Cyclical Supply demand for these types J Factor - The role judges can play in return anticipating a bankruptcy ruling is unpredictable 12 13 Due Diligence Checkpoints (8) Fund of Funds Asses the Market oppty offered - What are the inefficiencies that are exploitable? Past returns don't matter Investment Process - What's your competitive edge? Asses the organization - Is it stable? Turnover? Asses the people - Character, integrity, & competence Terms/Structure = Fees? Do they align? Lockout? What is their exit strategy Asses Service Providers - Investigate the outside firms that support mangers business (lawyers, brokers, staff) Review Docs - Prospectus, Memos, Audits, etc Write up - Document the proces 10-30 Managers More Fees Better Liquidity Cash Drag Good entry level investment better benchmark then some indices Need to watch style drift More Correlated to Stocks then individual funds 14 Hedge Funds Types (9) Convertible Arbitrage - Exploits mispricings of convertible bonds Buy undervalued bond and short the stock Hedges the stock and you collect yields Benefits from Stock Volatility Distress Securities - Long Only Emerging Markets - Long Only - No Hedge MKT neutral - Pairs trading to bet on unsystematic moves Hedged Equities - L/S w/ Systematic Risk Fixed Income Arb L/S fixed income to play yield curve 7.Global Macro - Plays derivatives and currencies of countries Merger Arb Bets on Managers L/S Fund of Funds 15 Issues w/ AI for Private Clients (5) Taxes - Many AI In are LPS that require tax expertise Suitability - Is Lockup aligned w./ investors horizon and liquidity needs? Communication - Can you properly explain the investment? Do they get it Decision Risk - Risk of emotionally abandoning the strategy at the point of max loss Effectively explain ups and downs Concentrated Positions - Does their outside investments give them exposure already? 16 Managed Futures Performance Commodity Pool Operators - CPOS Commodity Trade Advisors - CTAs CTA either Systematic (rules) or Discretionary (No rules) Private Pools tend to better then public funds Watch correlation between CTA and CTA's beta 17 Managed Futures Prices Total Return = Spot Return + Collateral Return + Roll Return Spot Return: Return of the commodity itself Collateral Return: Periodic Risk Free rate Roll Yield: Change in futures contract price Change in spot price Backwardation: \ Curve each futures price is lower then past positive roll yield Contango: / newer futures prices are higher then previous Negative Roll yield Roll Return - Change Futures Price - Change in spot return 18 Monthly Indices CISDM - Covers Hedge Funds and Mng Futures - Equal weight Credit Suisse/Tremont - Broken down by strategies - AUM weighted EACM - Broad Hedge 100 funds equal weight HFI - Equal Weight 50 funds HF.net - Equal weight by strategies 19 Performance Evaluation - Create a multi-factor model or tracking portfolios w/ similar risk return Analyst should look at fees, lockups, age of funds, size -Longer Lockup = better return -Younger funds outperform older ones -Large funds outperform smaller ones Returns Calc'd Monthly, then compounded annually Returns are biased by entry exit on quarterly basis and by cash flows Rolling 12 month returns are common St Deviation may have misleading results due to Skewness and fat tails 20 Sharpe Ratio Limitations on HFs -Time Dependancy - Biased Upward -Assumes Normality -Assumes Liquidity - Upward bias for illiquidity -Assumes uncorrelated Return -It's a standalone measure - Doesn't take into account affects of diversification Can be manipulated by managers ... Prospectus, Memos, Audits, etc Write up - Document the proces 10 -30 Managers More Fees Better Liquidity Cash Drag Good entry level investment better benchmark then some indices Need to watch... Factor - The role judges can play in return anticipating a bankruptcy ruling is unpredictable 12 13 Due Diligence Checkpoints (8) Fund of Funds Asses the Market oppty offered - What are the inefficiencies... inflation provide good diversification w/ exp inflation Non Storable - Agriculture - Not a good hedge Level Demand (Agric) - Bad Hedge Economic Demand (gold) - Good hedge 10 Daily Indices HFR DJ & S&P