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2018 Study Session # 13, Reading # 26 “ALTERNATIVE INVESTMENTS PORTFOLIO MANAGEMENT” AI = Alternative Investments HF = Hedge Funds MF = Managed Futures PE = Private Equity PS = Preferred stock RE = Real Estate CREFS = Commingled Real Estate Funds REITS = Real Estate Investment Trusts PIPE = Private Investment in Public Entity INTRODUCTION High net-worth individuals & institutional investors invest in alternative classes for risk reduction & to apply active management skills or both There are six diverse groups of alternative investments (real estate, private equity, commodities, hedge funds, managed futures & distressed securities) Due diligence ⇒ investigation into details of potential investment GP = General Partner FOF = Fund of Funds AM = Arithmetic Mean GM = Geometric Mean CY = Convenience Yield HWM = High Water Mark MVO = Mean Variance Optimization SD = Standard Deviation DD = Downside Deviation VC = Venture Capital ALTERNATIVE INVESTMENTS: DEFINITIONS, SIMILARITIES, AND CONTRASTS Alternative investments⇒ comprise group of investments with risk & return 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 Traditional Alternative Investments Private Equity Commodities Real Estate Modern Alternative Investments Hedge Funds Managed Futures Distressed Securities Traditional Investments Stocks Bonds Modern alternative investments are more akin to investments or trading strategies than to asset classes AI role in portfolio: Exposure to risk factors not accessible through stocks & bonds (real estate & long only commodities) 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 Market Opportunity Type of market opportunity Reasons for opportunity (regulatory structure or behavioral bias) Usually history of past active return is meaningless Investment Process Identify group of managers that seek to exploit these inefficiencies Competitive advantage of managers Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Active Manager Selection Process Organization People Is the firm well organized & stable? Compensation, turnover & succession plan Consider trustworthiness of people Speak at length of principal face to face Reference checks Terms & Structure Service Providers Check whether fund or account structured appropriately to the opportunity Verify lawyers, auditors, prime brokers, lenders etc Documents Write-Up Read prospectus & private placement memorandum Hire lawyers if we not understand everything Produce a formal manager recommendation It ensures organized thoughts, informs others & formally documents the process Due Diligence Questions Unique to Individual Clients Tax Issues Determining Suitability Advisers frequently dealing with structures that have distinct tax issues Complex for individual due to multi stage time horizon & liquidity needs Distinct emotional & financial needs Communication with Client Decision Risk Advisors face communication problem (complex investment, non professional investors) Risk of changing strategies at a point of maximum loss Issue relates to downside risk at all points within a time horizon & investor’s reaction to it Negative skewness, kurtosis, decision risk Concentrated Equity Concentrated equity position should be considered while investing in private equity Home value must be considered while investing in real estate Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 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 Real estate management & development subsector REITS Companies holding RE ownership, development or management According to GICS & FTSE industry classification benchmarks Equity REITS Own & manage mortgage properties Rental income + capital appreciation CREFS Professionally managed vehicles investments in RE Investments in RE can be open-end & closed-end CREFs funds Closed end funds use leverage & have return objectives Publicly traded equities representing RE properties & / or RE debt investments REITS returns are dependent on underlying RE holdings Mortgage REITS More than 75% of the assets are mortgages Interest income + capital appreciation Hybrid REITS Mix of the equity & mortgage REITS Infrastructure Funds Private investments in public projects (e.g roads schools etc.) Usually investment through consortium of private companies Govt leases the project& pay annual fees (avoid debt & tax ) Consortium often sells its equity portion to investors through a variety of structures 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 document) Copyright © FinQuiz.com All rights reserved Separately Managed Accounts Often offered by the CREFs sponsoring advisors Important alternative to CREFs 2018 Study Session # 13, Reading # 26 3.2 Benchmarks and Historical Performance 3.2.1 Benchmarks NCREIF NAREIT 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 not include client’s residencies as marketable assets 3.3.1 Investment Characteristics RE is an asset (has 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 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Direct Equity RE Investing Advantages Disadvantages 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 Tactical asset allocation⇒ good forecasting of 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 Good income enhancer REITS provide some diversification benefits relative to traditional investments portfolio but no benefits to a portfolio consisting of 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 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 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 PE funds ⇒ pooled investments in highly illiquid assets Fields of PE Venture Capital Buyout 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 PIPE Large investments in a public company usually at a price less than the current MV Capacity issues in PE ⇒ limited supply of winning ideas for 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 Formative stage companies ⇒ raise capital through marketing of an effective business plan Private placement memorandum ⇒ a document that is used to raise funds through an agent Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Venture Capital Demand Supply Formative-stage companies ⇒ ranges from newly to young companies Expansion-stage companies ⇒ ranges from young to established companies (preparing for IPO) Angel investors Seed & early stage investors Relatively small but risky investment Usually the 1st outside investors Financing Stages Venture Capital Early-Stage Later-Stage Pools of capital managed by specialists (venture capitalists) Board representations & provide significant expertise in addition to capital VC trusts ⇒ exchange traded, closed-end vehicles Fund for sales (generally for promising companies) Seed Stage ⇒ small amount of financing to form a company & to prove a successful idea Start-up ⇒ pre-revenue stage to bring the product or idea to commercialization First stage ⇒ additional funds if company has exhausted its seed & start up financing Large Companies Corporate venturing ⇒ major companies’ investment in promising young companies in the same or related industry Strategic partners ⇒ investors of corporate venturing Exit from PE is often difficult & in following ways IPO Merger with or acquisition by another company PE Funds VC Funds Buyout Funds Relatively small in size than buyout funds Mega-Cap Take public companies private Middle-Cap Purchase private companies with small revenues & profits Dividend recapitalization ⇒ issuance of debt to finance a special dividend to owners Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 4.1.1 Types of Private Equity Investment Direct VC Investment Indirect Investment (through PE funds) Structured as convertible preferred stock rather than common stock Shares of later rounds of financing are more valuable than earlier round shares Investment through VC & buyout funds PE Fund Structure Limited Partnership Limited Liability Companies 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 a managing director PE FOF ⇒ invests in other PE funds (double fees structure) Fund Manager Compensation Management Fee Carried Interest 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 Claw back provision ⇒ fund manager will 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 4.2.1 Benchmarks Major benchmarks for VC & buyout funds ⇒ Cambridge associates & Thomson venture economics Custom benchmarks are also used 4.2.2 Historical Performance PE returns have low correlation with publicly traded securities Correlation & return may suffer from stale price bias Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 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 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 4.3.3 Other Issues Due Diligence Portfolio Company PE Fund 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 Management’s commitment Management’s experience & capabilities % ownership Compensation incentives Cash invested Identity of current investors Opinion of customers Operational Review Employment contracts Intellectual property Expert validation of technology Financial/Legal Review Examination of financial statements Potential for dilution of interest COMMODITY INVESTMENTS Commodity ⇒ tangible asset that is relatively homogenous in 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 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 5.1.1 Types of Commodity Investments Direct Commodity Investment Indirect Commodity Investment 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 hedge 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) Rj / CRB index ⇒ four sectors with fixed unequal weights GSCI index ⇒world-production weighting scheme AM or GM to calculate index return from the component return Two version of indices: Total return version ⇒ assumes that capital sufficient to purchase basket of commodities is invested at Rf Spot version⇒ tracks only futures price movement 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 equities but not bonds (correlations remain same but return ∆ with respect to equity) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Commodity Index Return Components Spot or Price Return 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 5.2.3 Interpretation Issues Commodities are a distinct asset class if commodity indices are used as benchmark If commodities don’t receive separate treatment ⇒ customized benchmark 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 Copyright © FinQuiz.com All rights reserved Roll Return 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 2018 Study Session # 13, Reading # 26 5.3.2 Roles in the Portfolio Commodities are considered as a 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 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 Convertible Arbitrage Identify overvalued & undervalued equity securities Neutralize portfolio’s exposure to market risk (through long & short positions) Exploit price anomalies in corporate convertible securities Examples ⇒ buying the convertible bond & shorting the associated stock Fixed Income Arbitrage Distressed Securities Through identifying misvalued securities Credit quality or term structures of IR are key considerations Debt & equity investment in companies that are in or near bankruptcy Illiquid securities ⇒ short sales are difficult (mainly long position) Merger Arbitrage Hedged Equity To capture price spread (diff b/w current price & price after take over) Example ⇒ post merger long position on target & short on acquirer Portfolios not structured to market, industry sector or $ neutral Try to identify misvalued securities Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 6.1.1 Types of Hedge Fund Investments Global Macro Fund of funds To take advantage of systematic moves in financial & non-financial markets Concentrate on market trends (macro focus) Sometimes managed futures are classified under it Fund that invests in a no of underlying HF Diversification Two layers of fees Emerging Markets Funds with less mature &emerging market focus Usually long position because short selling is not allowed Groups of HF Strategies Relative Value Event Driven Exploit valuation discrepancies Through long/short positions Examples ⇒ equity market neutral convertible arbitrage Equity Hedge Long/short equity position Varying degree of equity market exposure & leverage To create value through corporate transactions Examples ⇒ merger arbitrage, distressed securities Short Selling Short equities with the expectation of market Global Asset Allocator Opportunistically long/short positions on financial/nonfinancial assets Compensation Structure of HF Management or AUM fees ⇒ generally ranges from 1% to 2% of asset under management (AUM) Incentive fee ⇒ % of profits specified by the terms of the investment HWM provision ⇒ NAV level that a fund must exceed before performance fees are paid to HF manager Purpose of HWM provision ⇒ incentive fees is paid only once for the same gain If two funds are of similar size & strategy, it is expected that fund with lower management fee will deliver superior performance Funds with lock up periods specify exit windows (rationale ⇒ avoid unwinding positions unfavorably) FOF usually not impose lock up periods ⇒ require additional liquidity & expected return 6.2 Benchmarks and Historical Performance HF not provide sufficient means for monitoring & rebalancing Research has also focused on developing indices for strategies ( misfit risk if reference benchmark is not a complete tracking portfolio) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 6.2.1 Benchmarks Monthly Benchmarks Daily Benchmarks CISDM of the university of Massachusetts Credit Suisse/ Tremont ECAM advisor Hedge fund intelligence Ltd Hedge fund net HFR MSCI Dow Jones hedge fund strategy benchmarks HFR hedge fund indices MSCI hedge invest index Standard & poor’s hedge fund indices Comparison of Major Manager-Based Hedge Fund Indices Determine whether HF indices are investable & list the actual funds used in benchmark construction Daily indices are generally constructed from managed accounts of an asset manager rather than from the funds themselves Difference in construction of the manager-based HF indices include: Selection criteria difference Different style classification Different weighting & rebalancing schemes Investability Alpha Determination and Absolute-Return Investing HF are often promoted as absolute return vehicles (no direct benchmark), so alpha determination is difficult Problems in alpha determination: Difference in selected benchmark Investible benchmark is required Consider all sources of systematic risk 6.2.2 Historical Performance During periods of 1990-2004 HF outperform equities & bonds on a risk adjusted basis During period of 2000-2004, HF outperforms U.S & world equities but not bonds Equity market neutral & managed futures are considered risk diversifiers (low correlation with equity market) Equity hedge funds are considered return enhancers ( correlation with equity markets) There is a difference in correlations among HF strategies due to difference in sensitivities to various market factors 6.2.3 Interpretation Issues Diff in HF indices returns due to diff in HF strategy weights Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Biases in Index Creation Most HF databases are self reported Low correlation among similar strategy indices is because of: Size & age restriction Diff in weighting schemes Weighting Schemes Value weighting Equal weighting Momentum effect (popularity bias) Index is difficult to track Provide diversification benefits Rebalancing cost Creating a single, all encompassing HF index does not appear to be feasible HF investors also use custom or negotiated benchmarks Relevance of Past Data on Performance Research shows that volatility of returns persist through time than the level of returns Composition of HF indices also change which will cause more severe problems for valueweighted indices than equal weighted Biases Survivorship Bias Stale Price Bias Only surviving managers (good track record) remain in HF data base Overestimation of historical return Survivorship bias can be through superior due diligence FOFs have screened funds (reduce survivorship bias) Lack of security trading may lead to stale price bias SD may or & measured correlations may Very little evidence of the presence of this bias in HF Backfill (Inclusion Bias) Filling of missing past data when a component joins the index Makes results look too good Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 6.3 Hedge Funds: Investment Characteristics and Roles HF are skill-based investment strategies (return through competitive advantages in information or its interpretation) Significant market opportunities are required to utilize these strategies 6.3.1 Investment Characteristics HF strategies may be used as return enhancer or risk diversifier Analysis of underlying factors used in trading strategies is important when deciding which HF to include in a portfolio 6.3.2 Roles in the portfolio FOF are popular investment vehicles at entry level (provide diversification, due diligence, two layers of fees) The Role of Hedge Funds as a Diversifier Asset allocations produced by MVO are: Sensitive to errors in return estimates Not suitable for HF strategies due to option-like characteristics of HF strategies Historical Performance Inclusion of HF in portfolio resulted in a mean-variance improvement (due to its lower skewness & high kurtosis) Techniques for neutralizing –ve skewness: Adopt a mean-variance, skewness & kurtosis aware approach Invest in managed futures 6.3.3 Other Issues Fund-specific factors Young funds outperform old funds on total return basis Small funds outperform large funds Return of FOFs are close to returns of HF indices Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Relationship b/w Fund Factors & HF Return Performance Fees & Lock-Up Impact Funds of Funds Funds with quarterly lock-up have returns than with monthly lock-up funds Funds dissolved during severe drawdown, rather than not to earn incentive fees Less direct impact of survivorship bias Classification & style drift (not fit into strict asset allocation) Effect of Fund Size Age (vintage) Effects Comparison is difficult among funds with different lengths of track record Performance of median manger of same vintage can be revealing Funds with large asset base attract talented people, receive more attention of their prime brokers than small fund Historically, large funds earns lower mean return than small funds Evaluate the effect of fund size on a case-bycase basis Hedge Fund Due Diligence Hedge funds rarely disclose their existing portfolio position (provide annual audited reports & performance review) Possible concerns: Authenticity of performance is doubtful without position report Risk management is difficult without disclosure of portfolio positions Certain due diligence check points are available as a guide for investors 6.4 Performance Evaluation Concerns Typically HF performance evaluation & reporting is monthly Monthly holding period return = ୬ୢ୧୬ ୴ୟ୪୳ୣ ୭ ୮୭୰୲୭୪୧୭ିୣ୧୬୧୬୧୬ ୴ୟ୪୳ୣ ୭ ୮୭୰୲୭୪୧୭ ୣ.୭୰୲୭୪୧୭ ୟ୪୳ୣ this return can be compounded annually or quarterly HF industry looks through the leverage as if the asset were fully paid (affect the weight of asset in the portfolio, not the returns on the individual asset) Rolling return to HF ܴܴ,௧ = (ܴ௧ + ܴ௧ିଵ + ܴ௧ିଶ + ⋯ + ܴ௧ିሺିଵሻ )⁄݊ Reflect return consistency & identify cyclicality in the return Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Volatility &Downside Volatility SD: SD of monthly return as measure of risk in HF: ݐ݊݉ = ܦܵ ݀݁ݖ݈݅ܽݑ݊݊ܣℎ݈√ × ܦܵ ݕ12 Assumption ⇒ returns are normally distributed (not suitable for HF, because of excess kurtosis & negative skewness) SD penalizes high positive returns Downside deviation: Deviation from a specified threshold (only –ve deviations are considered in calculation) DD distinguish b/w good& bad volatility = ܦܦට ∑ሾ୫୧୬ሺ ି ∗ ,ሻሿమ ିଵ Drawdown: Diff b/w HWM & subsequent low Max drawdown ⇒ largest diff b/w HWM & subsequent low Performance Appraisal Measures ܵℎܽ= ݅ݐܽݎ ݁ݎ ௨௭ௗ ௧ ௧௨ି௨௭ௗ ோோ ௨௭ௗ ௌ Limitations of Sharpe ratio: Time dependent ⇒ proportionally with square root of time Not suitable when asymmetrical return distribution Illiquid holdings ⇒ sharpe ratio will biased upward Serially correlated return ⇒sharpe ratio is overestimated Ratio ignores correlations with other assets in the portfolio Ratio has no predictive ability for HF Sharpe ratio can be gamed through: Lengthening the measurement interval Compounding the monthly return but calculating the SD from (not compounded) monthly return Writing out-of-money puts & calls on portfolio Smoothing & getting rid of extreme returns Sortino ratio ⇒replaces SD in sharpe ratio with downside deviation ܵ = ݅ݐܽݎ ݊݅ݐݎ ௨௭ௗ ௧ ௧௨ି௨௭ௗ ோோ ݊݅ܽܩ− ݐ− = ݅ݐܽݎ ݏݏܮ ௪௦ௗ ௗ௩௧ ௦௧௩ ௧௨ ௧௦ ே௧௩ ௧௨௦ ௧௦ × ௩ ି௧ ௧௨ ௩ ௗ௪ି௧ ௧௨ the ratio, the better it is Correlations Most meaningful when returns are normally distributed Skewness & Kurtosis Skewness ⇒ measures asymmetry in return distribution Kurtosis ⇒ measures how return are cluster near the mean or away from the mean Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 Consistency More relevant when comparing funds of the same style or strategy A fund is considered consistent if it has greater % of +ve return & less % of –ve return than the benchmark in all market conditions MANAGED FUTURES Actively managed private pooled investment vehicles that invest cash, spot & derivative markets & use leverage Difference b/w HF & MF MF trade exclusively in derivative markets while HF tends to be more active in spot market MFs are macro focused while HFs are mainly micro focused 7.1 The Managed Futures Market MF are skill-based absolute-return strategies MF programs are available in separately managed accounts & private & publicly traded commodity funds Trading Strategies of MF Systematic trading strategies Discretionary trading strategies Rule-based trading model Most systematic CTAs invest in trend following programs Trade financial, currency & commodity derivatives Involve portfolio manager’s judgment 7.2 Benchmarks and Historical Performance 7.2.1 Benchmarks Investable benchmark exists for active derivative strategies Mount Lucas is a trading rule based index for active momentum strategy CISDM CTA ($ weighted & equal weighted) indices are available for systematic v/s discretionary strategies 7.2.2 Historical Performance Over the period of 1990-2004, MF outperforms the equity but underperforms the bonds Correlation of MF with equity is slightly –ve but correlations with bonds is lower positive Results for a more recent period (200-2004) are qualitatively similar Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 7.2.3 Interpretation Issues Survivorship bias in MF can result in returns Investment results can be significantly different if investors are able to forecast surviving managers 7.3 Managed Futures: Investment Characteristics and Roles 7.3.1 Investment Characteristics Long-term passively managed unlevered futures position ⇒ earns Rfmanagement fee &transaction costs To earn more than Rf, sufficient no of hedgers should be there who systematically earn less than Rf Arbitrage is possible when derivative relationships are out of equilibrium Managed derivative strategies follow momentum strategies (positive skewness to managed fund returns) Managed futures strategies are lower cost strategies than cash market strategies Provide investors with exposure to unique sources of return Short positions can easily be taken in futures 7.3.2 Roles in the Portfolio For the period of 1990-2004, managed futures would have been a valuable addition to stock/bond/hedge fund portfolio For 2000-2004 the results are qualitatively similar 7.3.3 Other Issues There is some evidence of performance persistence in MF Performance measurement CTAs β with respect to an index of CTAs is a good predictor of future relative return MF uses same due diligence process as in HF (because of leverage & use of derivatives) DISTRESSED SECURITIES Distressed securities ⇒ securities of companies that are in financial distress or near bankruptcy Due to IPS or regulatory restrictions, many investors are unable to hold investment-grade securities Provide opportunities to knowledgeable investors which are mostly HF & PE funds Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 8.1 The Distressed Securities Market 8.1.1 Types of Distressed Securities Investments Hedge Fund Structure Private Equity Fund Structure Dominant type New capital inflows can be taken on a continuing basis AUM fee & incentive structure More liquidity than other structure Closed-end with a fixed term Suitable when assets are highly illiquid or difficult to value NAV fee structure may be problematic (assets are difficult to value) Hybrid Structures Mix of HF & PE Fund Structures 8.2 Benchmarks and Historical Performance 8.2.1 Benchmarks A distressed security investing is often classified as a sub-style of event-driven HF strategy All major HF indices have a sub-index for distressed securities 8.2.2 Historical Performance Return distribution for distressed securities is distinctly non-normal & can be quite rewarding Significant downside risk is present in distressed securities (negative skewness & excess kurtosis) so Sharpe ratio is not a suitable measure For the period of 1990-2004, distressed securities outperformed all stocks & bonds investments Distressed securities strategy outperforms when economy is not doing well 8.2.3 Interpretation Issues Distressed bonds ⇒ highest credit-risk segment of the high-yield bond market 8.3 Distressed Securities: Investment Characteristics and Roles 8.3.1 Investment Characteristics Fallen angels ⇒ debt that has crossed the threshold from investment grade to high yield In a reorganization process, old equity may be wiped out & new shares are issued to creditors & sold to public Special skills & deep experience of credit & business valuation is required in distressed securities Copyright © FinQuiz.com All rights reserved 2018 Study Session # 13, Reading # 26 8.3.2 Role in the Portfolio Long-Only Value Investing Distressed Debt Arbitrage Investment in perceived undervalued distressed securities Orphan equity investing ⇒ investment in newly issued equity of a company emerging from reorganization Long on debt & short on equity of bankrupt companies In case of , equity will more (because of residual claim) In case of , debt will more (senior claim) Private Equity Active approach that involves corporate activism Investors become creditors & influence the reorganization process to the value of a troubled company Variation of the active approach ⇒ prepackaged bankruptcy (converting distressed debt to private equity) After restoring, the company can be sold to private or public investors Vulture investor⇒ proactive or aggressive investor trying to protect & the value of his claims Distressed securities strategies may entail one or more of the following risks Event risk ⇒ company specific, low correlation with stock market Market liquidity risk ⇒ liquidity is very much low & can be highly cyclical in nature Market risk ⇒ not as important as liquidity risk J factor risk ⇒ due to involvement of judges in bankruptcy process Stale pricing makes the distressed securities appear less risky (Sharpe ratio ) Distressed securities investing require sources of distress &legal, financial & operational analysis Copyright © FinQuiz.com All rights reserved ... purchase from limited partners seeking liquidity Copyright © FinQuiz. com All rights reserved 2018 Study Session # 13, Reading # 26 4 .3. 3 Other Issues Due Diligence Portfolio Company PE Fund Due... CREFs sponsoring advisors Important alternative to CREFs 2018 Study Session # 13, Reading # 26 3. 2 Benchmarks and Historical Performance 3. 2.1 Benchmarks NCREIF NAREIT To measure performance of direct... Correlation & return may suffer from stale price bias Copyright © FinQuiz. com All rights reserved 2018 Study Session # 13, Reading # 26 4.2 .3 Interpretation Issues IRR calculation based on appraised
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