© CFA Institute For candidate use only Not for distribution ALTERNATIVE INVESTMENTS AND PORTFOLIO MANAGEMENT CFAđ Program Curriculum 2020 ã LEVEL II ã VOLUME â CFA Institute For candidate use only Not for distribution © 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute All rights reserved This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself It does not cover the individual selections herein that first appeared elsewhere Permission to reprint these has been obtained by CFA Institute for this edition only Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org This publication is designed to provide accurate and authoritative information in regard to the subject matter covered It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service If legal advice or other expert assistance is required, the services of a competent professional should be sought All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only ISBN 978-1-946442-87-1 (paper) ISBN 978-1-950157-11-2 (ebk) 10 © CFA Institute For candidate use only Not for distribution CONTENTS How to Use the CFA Program Curriculum Background on the CBOK Organization of the Curriculum Features of the Curriculum Designing Your Personal Study Program Feedback vii vii viii viii x xi Alternative Investments Study Session 15 Alternative Investments Reading 39 Private Real Estate Investments Introduction Real Estate Investment: Basic Forms Real Estate: Characteristics and Classifications Characteristics Classifications Private Market Real Estate Equity Investments Risk Factors Real Estate Risk and Return Relative to Stocks and Bonds Commercial Real Estate Overview of the Valuation of Commercial Real Estate Appraisals Introduction to Valuation Approaches The Income Approach to Valuation General Approach and Net Operating Income The Direct Capitalization Method The Discounted Cash Flow (DCF) Method Advanced DCF: Lease-by-Lease Analysis Advantages and Disadvantages of the Income Approach Common Errors The Cost and Sales Comparison Approaches to Valuation The Cost Approach The Sales Comparison Approach Advantages and Disadvantages of the Cost and Sales Comparison Approaches Reconciliation Due Diligence Valuation in an International Context Indexes Appraisal-Based Indexes Transaction-Based Indexes Advantages and Disadvantages of Appraisal-Based and TransactionBased Indexes Private Market Real Estate Debt indicates an optional segment 9 11 13 15 17 19 22 22 25 27 28 29 33 41 45 45 46 46 51 53 53 54 56 57 58 59 60 61 © CFA Institute For candidate use only Not for distribution ii Contents Summary Practice Problems Solutions Reading 40 Reading 41 64 67 74 Publicly Traded Real Estate Securities Introduction Types of Publicly Traded Real Estate Securities Publicly Traded Equity REITs Market Background REIT Structure Investment Characteristics Considerations in Analysis and Due Diligence Equity REITs: Property Subtypes Economic Drivers Real Estate Operating Companies Valuation: Net Asset Value Approach Accounting for Investment Properties Net Asset Value Per Share: Calculation Net Asset Value Per Share: Application Valuation: Relative Value (Price Multiple) Approach Relative Value Approach to Valuing REIT Stocks Funds from Operations and Adjusted Funds from Operations P/FFO and P/AFFO Multiples: Advantages and Drawbacks Valuation: Discounted Cash Flow Approach Considerations in Forecasting Longer-Term Growth Rates Some Perspective on Long-Term Growth Rates REIT Valuation: Mini Case Study Checking the Valuation: Analysis Based on Relative Valuation Further Analysis Based on Net Asset Value Per Share Further Analysis Based on a Dividend Discount Model Approach to Valuation Selection of Valuation Methods Summary Practice Problems Solutions 79 79 80 82 82 84 84 90 91 94 96 98 98 99 101 104 104 105 108 110 110 111 113 119 120 Private Equity Valuation Introduction Introduction to Valuation Techniques in Private Equity Transactions How Is Value Created in Private Equity? Using Market Data in Valuation Contrasting Valuation in Venture Capital and Buyout Settings Valuation Issues in Buyout Transactions Valuation Issues in Venture Capital Transactions Exit Routes: Returning Cash to Investors Summary Private Equity Fund Structures and Valuation Understanding Private Equity Fund Structures What Are the Risks and Costs of Investing in Private Equity? 135 136 138 141 143 144 146 148 149 151 152 152 156 indicates an optional segment 121 122 125 127 132 © CFA Institute For candidate use only Not for distribution Contents iii Due Diligence Investigations by Potential Investors Private Equity Fund Valuation Evaluating Fund Performance Concept in Action: Evaluating a Private Equity Fund Solution to 1: Solution to 2: Prefatory Comments on the Case Study Summary Appendix: A Note on Valuation of Venture Capital Deals Practice Problems Solutions 158 158 159 161 163 163 164 165 166 178 184 Introduction to Commodities and Commodity Derivatives Introduction Commodities Overview Commodity Sectors Life Cycle of Commodities Valuation of Commodities Commodity Futures Markets Futures Market Participants Spot and Futures Pricing Futures Returns Commodity Swaps Commodity Indexes S&P GSCI Bloomberg Commodity Index Deutsche Bank Liquid Commodity Index Thomson Reuters/CoreCommodity CRB Index Rogers International Commodity Index Rebalancing Frequency Commodity Index Summary Summary Practice Problems Solutions 189 190 191 191 196 203 205 205 208 213 226 230 232 232 232 233 233 233 233 235 237 244 Study Session 16 Portfolio Management (1) 251 Reading 43 Exchange-Traded Funds: Mechanics and Applications Introduction ETF Mechanics The Creation/Redemption Process Trading and Settlement Understanding ETFs Expense Ratios Index Tracking/Tracking Error Tax Issues ETF Trading Costs 253 253 254 254 258 260 260 261 266 268 Reading 42 Portfolio Management indicates an optional segment © CFA Institute For candidate use only Not for distribution iv Reading 44 Reading 45 Contents Total Costs of ETF Ownership Risks ETFs in Portfolio Management ETF Strategies Efficient Portfolio Management Asset Class Exposure Management Active and Factor Investing Summary Practice Problems Solutions 273 275 279 280 280 282 284 286 289 292 Using Multifactor Models Introduction Multifactor Models and Modern Portfolio Theory Arbitrage Pricing Theory Multifactor Models: Types Factors and Types of Multifactor Models The Structure of Macroeconomic Factor Models The Structure of Fundamental Factor Models Multifactor Models: Selected Applications Factor Models in Return Attribution Factor Models in Risk Attribution Factor Models in Portfolio Construction How Factor Considerations Can Be Useful in Strategic Portfolio Decisions Summary Practice Problems Solutions 295 295 296 297 303 303 304 307 311 311 314 318 Measuring and Managing Market Risk Introduction Understanding Value at Risk Value at Risk: Formal Definition Estimating VaR Advantages and Limitations of VaR Extensions of VaR Other Key Risk Measures—Sensitivity and Scenario Measures Sensitivity Risk Measures Scenario Risk Measures Sensitivity and Scenario Risk Measures and VaR Applications of Risk Measures Market Participants and the Different Risk Measures They Use Using Constraints in Market Risk Management Risk Budgeting Position Limits Scenario Limits Stop-Loss Limits Risk Measures and Capital Allocation 333 334 335 335 338 349 352 354 355 359 364 368 369 377 378 379 379 380 380 indicates an optional segment 321 321 324 329 © CFA Institute For candidate use only Not for distribution Contents v Summary Practice Problems Solutions 382 385 394 Study Session 17 Portfolio Management (2) 399 Reading 46 Economics and Investment Markets Introduction Framework for the Economic Analysis of Financial Markets The Present Value Model Expectations and Asset Values The Discount Rate on Real Default-Free Bonds Real Default-Free Interest Rates Default-Free Interest Rates and Economic Growth Real Default-Free Interest Rates and the Business Cycle The Yield Curve and the Business Cycle Short-Term Nominal Interest Rates and the Business Cycle Treasury Bill Rates and the Business Cycle Short-Term Interest Rate Summary Conventional Government Bonds The Default-Free Yield Curve and the Business Cycle Credit Premiums and the Business Cycle Credit Spreads and the Credit Risk Premium Industrial Sectors and Credit Quality Company-Specific Factors Sovereign Credit Risk Credit Premium Summary Equities and the Equity Risk Premium Equities and Bad Consumption Outcomes Earnings Growth and the Economic Cycle How Big is the Equity Risk Premium? Valuation Multiples Investment Strategy Commercial Real Estate Regular Cash Flow from Commercial Real Estate Investments The Pricing Formula for Commercial Real Estate Commercial Real Estate and the Business Cycle Summary Practice Problems Solutions 401 402 402 402 405 405 406 414 417 424 425 426 431 432 435 447 449 453 455 455 458 459 460 461 466 467 470 474 474 475 477 479 483 488 Reading 47 Analysis of Active Portfolio Management Introduction Active Management and Value Added Choice of Benchmark Measuring Value Added Decomposition of Value Added Comparing Risk and Return The Sharpe Ratio 493 493 494 494 495 497 499 499 indicates an optional segment © CFA Institute For candidate use only Not for distribution vi Reading 48 Contents The Information Ratio Constructing Optimal Portfolios The Fundamental Law of Active Management Active Security Returns The Basic Fundamental Law The Full Fundamental Law Ex Post Performance Measurement Applications of the Fundamental Law Global Equity Strategy Fixed-Income Strategies Practical Limitations Ex Ante Measurement of Skill Independence of Investment Decisions Summary Practice Problems Solutions 502 504 509 510 514 516 519 521 521 528 534 534 535 537 540 549 Trading Costs and Electronic Markets Introduction Costs of Trading Dealer Quotes Bid–Ask Spreads and Order Books Implicit Transaction Cost Estimates Effective Spreads Implementation Shortfall VWAP Transaction Cost Estimates Market Developments Electronic Trading Advantages of Electronic Trading Systems Electronification of Bond Markets Market Fragmentation Effects on Transaction Costs Types of Electronic Traders Electronic Trading System Facilities Why Speed Matters Fast Communications Fast Computations Advanced Orders, Tactics, and Algorithms Select Examples of How Electronic Trading Changed Trading Strategies Electronic Trading Risks The HFT Arms Race Systemic Risks of Electronic Trading Real-Time Surveillance for Abusive Trading Practices Summary Practice Problems Solutions 555 555 556 557 557 558 559 560 560 562 563 563 564 564 565 565 569 569 570 571 572 Glossary G-1 indicates an optional segment 575 577 577 578 582 585 587 590 © CFA Institute For candidate use only Not for distribution vii How to Use the CFA Program Curriculum Congratulations on reaching Level II of the Chartered Financial Analyst® (CFA®) Program This exciting and rewarding program of study reflects your desire to become a serious investment professional You have embarked on a program noted for its high ethical standards and the breadth of knowledge, skills, and abilities (competencies) it develops Your commitment to the CFA Program should be educationally and professionally rewarding The credential you seek is respected around the world as a mark of accomplishment and dedication Each level of the program represents a distinct achievement in professional development Successful completion of the program is rewarded with membership in a prestigious global community of investment professionals CFA charterholders are dedicated to life-long learning and maintaining currency with the ever-changing dynamics of a challenging profession The CFA Program represents the first step toward a career-long commitment to professional education The CFA examination measures your mastery of the core knowledge, skills, and abilities required to succeed as an investment professional These core competencies are the basis for the Candidate Body of Knowledge (CBOK™) The CBOK consists of four components: ■ A broad outline that lists the major topic areas covered in the CFA Program (https://www.cfainstitute.org/programs/cfa/curriculum/cbok); ■ Topic area weights that indicate the relative exam weightings of the top-level topic areas (https://www.cfainstitute.org/programs/cfa/curriculum/overview); ■ Learning outcome statements (LOS) that advise candidates about the specific knowledge, skills, and abilities they should acquire from readings covering a topic area (LOS are provided in candidate study sessions and at the beginning of each reading); and ■ The CFA Program curriculum that candidates receive upon examination registration Therefore, the key to your success on the CFA examinations is studying and understanding the CBOK The following sections provide background on the CBOK, the organization of the curriculum, features of the curriculum, and tips for designing an effective personal study program BACKGROUND ON THE CBOK The CFA Program is grounded in the practice of the investment profession Beginning with the Global Body of Investment Knowledge (GBIK), CFA Institute performs a continuous practice analysis with investment professionals around the world to determine the competencies that are relevant to the profession Regional expert panels and targeted surveys are conducted annually to verify and reinforce the continuous feedback about the GBIK The practice analysis process ultimately defines the CBOK The © 2019 CFA Institute All rights reserved viii © CFA Institute For candidate use only Not for distribution How to Use the CFA Program Curriculum CBOK reflects the competencies that are generally accepted and applied by investment professionals These competencies are used in practice in a generalist context and are expected to be demonstrated by a recently qualified CFA charterholder The CFA Institute staff, in conjunction with the Education Advisory Committee and Curriculum Level Advisors that consist of practicing CFA charterholders, designs the CFA Program curriculum in order to deliver the CBOK to candidates The examinations, also written by CFA charterholders, are designed to allow you to demonstrate your mastery of the CBOK as set forth in the CFA Program curriculum As you structure your personal study program, you should emphasize mastery of the CBOK and the practical application of that knowledge For more information on the practice analysis, CBOK, and development of the CFA Program curriculum, please visit www.cfainstitute.org ORGANIZATION OF THE CURRICULUM The Level II CFA Program curriculum is organized into 10 topic areas Each topic area begins with a brief statement of the material and the depth of knowledge expected It is then divided into one or more study sessions These study sessions—17 sessions in the Level II curriculum—should form the basic structure of your reading and preparation Each study session includes a statement of its structure and objective and is further divided into assigned readings An outline illustrating the organization of these 17 study sessions can be found at the front of each volume of the curriculum The readings are commissioned by CFA Institute and written by content experts, including investment professionals and university professors Each reading includes LOS and the core material to be studied, often a combination of text, exhibits, and in-text examples and questions A reading typically ends with practice problems followed by solutions to these problems to help you understand and master the material The LOS indicate what you should be able to accomplish after studying the material The LOS, the core material, and the practice problems are dependent on each other, with the core material and the practice problems providing context for understanding the scope of the LOS and enabling you to apply a principle or concept in a variety of scenarios The entire readings, including the practice problems at the end of the readings, are the basis for all examination questions and are selected or developed specifically to teach the knowledge, skills, and abilities reflected in the CBOK You should use the LOS to guide and focus your study because each examination question is based on one or more LOS and the core material and practice problems associated with the LOS As a candidate, you are responsible for the entirety of the required material in a study session We encourage you to review the information about the LOS on our website (www cfainstitute.org/programs/cfa/curriculum/study-sessions), including the descriptions of LOS “command words” on the candidate resources page at www.cfainstitute.org FEATURES OF THE CURRICULUM OPTIONAL SEGMENT Required vs Optional Segments You should read all of an assigned reading In some cases, though, we have reprinted an entire publication and marked certain parts of the reading as “optional.” The CFA examination is based only on the required segments, and the optional segments are included only when it is determined that they might ... Practice Problems Solutions 189 190 191 191 196 20 3 20 5 20 5 20 8 21 3 22 6 23 0 23 2 23 2 23 2 23 3 23 3 23 3 23 3 23 5 23 7 24 4 Study Session 16 Portfolio Management (1) 25 1 Reading 43 Exchange-Traded Funds: Mechanics... Institute For candidate use only Not for distribution © 20 19, 20 18, 20 17, 20 16, 20 15, 20 14, 20 13, 20 12, 20 11, 20 10, 20 09, 20 08, 20 07, 20 06 by CFA Institute All rights reserved This copyright... Exposure Management Active and Factor Investing Summary Practice Problems Solutions 27 3 27 5 27 9 28 0 28 0 28 2 28 4 28 6 28 9 29 2 Using Multifactor Models Introduction Multifactor Models and Modern Portfolio