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2.
ALTERNATIVE INVESTMENTS
High fees
Low diversification of managers and investments
High leverage
Restrictions on redemptions.
12.
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Reading 60
Reading 60
NOTE:
Systemic risk is different from systematic risk. It is used in
the credit markets to indicate highly correlated default
risk.
Alpha return: Active investors assume that markets
are inefficient and provide opportunities to earn
positive excess return after adjusting for beta risk.
The positive excess beta risk adjusted return is
referred to as alpha return.
o For passive investors, expected alpha return = 0.
o Theoretically, alpha returns are uncorrelated with
beta returns.
o Typically, alternative investments are actively
managed with an objective to earn positive alpha
return.
Basic Alpha-seeking strategies (these are not mutually
exclusive):
1) Absolute return: Absolute return strategies seek to
generate returns that are unrelated to the market
returns. Benchmarks used by such strategies include:
Cash rate (i.e. LIBOR)
Real return target (return in excess of inflation)
Absolute, nominal return target (i.e. 7%)
Theoretically, beta of funds that use absolute return
strategies should be close to 0.
2) Market segmentation: Market segmentation refers to
opportunity available to more flexible investors to
quickly move capital from lower returns areas to
higher expected return areas when it is difficult to do
so for restricted or conservative investors due to
following reasons i.e.
Institutional, contractual, or regulatory restrictions on
traditional asset managers with regard to
investments e.g. constraints regarding use of
derivatives, investing in low quality or foreign
securities, managing portfolio relative to a particular
market index etc.
Different investment objectives or liabilities.
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Investment Structures
HEDGE FUNDS
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Practice: Example 2,
Volume 6, Reading 60.
Example:
Initial investment = $100 million
Hedge fund has 2 and 20 fee structure with no
hurdle rate.
Funds of funds has 1 and 10 fee structure.
Management fees are calculated on an annual
basis on assets under management at the beginning
of the year.
Management fees and incentive fees are
calculated independently.
Hedge fund has a 15% return for the year before
management and incentive fees.
FOF has a 10% return for the year after fees of hedge
funds.
Calculations:
Profit of hedge fund before fees = $100 million (15%)
= $15 million
Management fee = $100 million 2%
= $2 million
Incentive fee = $15 million 20%
= $3 million
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Practice: Example 3,
Volume 6, Reading 60.
Reading 60
Short Put.
Prime Brokers: Normally, hedge funds trade through
prime brokers. Besides trading on behalf of clients, prime
brokers provide following services:
Custody
Administration
Lending
Short borrowing
Practice: Example 4,
Volume 6, Reading 60.
3.4
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Practice: Example 5,
Volume 6, Reading 60.
3.5
Investment strategy
Investment process
Competitive advantage
Track record: Mostly, hedge funds are required to
have track record of at least 2 years. The longer the
track record period requirement, the more difficult it
is for hedge funds to raise capital.
Size and longevity: The older the fund, the better it is
because it reflects that the fund has experienced
lower losses and higher growth in assets under
management via both capital appreciation and
additional investments (capital injections).
o The minimum hedge fund size the investor can
consider depends on the minimum size of the
investments by investors and their investments
maximum % of a fund e.g. if an investors minimum
investment size is $15 million and the investors
maximum % of a fund is 8.5%, then
The minimum hedge fund size the investor can
consider = $15 million / 0.085 = $176.47 million
Management style
Markets in which the hedge fund invests
Hedge fund benchmarks
How returns are calculated and reported
Key-person risk
Reputation
Investor relations
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Practice: Example 6,
Volume 6, Reading 60.
PRIVATE EQUITY
Types of LBOs:
Management buyouts: MBO is similar to LBOs, however,
in MBOs, internal management acts as (co-) buyer of the
company and eventually become large investors in the
company after its privatization.
Management buy-ins (MBIs): In MBIs, the acquiring
company management replaces the current
management team.
B. Venture capital (VC): VC investments are private
equity investments used to finance a start-up (new)
business or growing private companies. Each
company in which the VC fund invests is referred to as
portfolio company. It involves various financing
stages i.e. formative-stage, expansion stage, pre-IPO
stage, and exit stage.
VC firms are active investors and actively manage
their portfolio companies. Typically, they have equity
interests in the portfolio companies.
VC investments require a long time horizon and are
subject to high risk of failures.
Due to higher risk of failure during early stage, earlystage investors demand higher expected returns
relative to later stage investors.
It represents a small portion of the private equity
market relative to LBOs.
Stages of Venture Capital Investing
A. Formative-stage financing includes seed stage and
early stage financing.
1) Seed-stage financing: In seed stage, small amount of
money is provided to form a company or to transform
the idea into a business plan and to assess market
potential.
In the initial seed-stage when business idea is being
transformed into a business plan, amount of capital
is typically small and is primarily provided by
founders, founders friends and family (called angel
investors) rather than by VC funds. This stage is also
known as Angel investing stage.
Later on, the seed capital is also provided by VC
funds to finance the product development and
market research.
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Practice: Example 7,
Volume 6, Reading 60.
4.5
REAL ESTATE
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3. Hybrid REITs: Hybrid REITs own & operate incomeproducing real estate properties and make loans as
well.
5.3
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5.4
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6.
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COMMODITIES
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Value to users
Global economic conditions
Supply of Commodities depend on:
Production levels
Inventory levels
Actions of non-hedging investors
o Supply of commodities is difficult to adjust quickly
to the changes in demand levels due to long lead
times associated with production. As a result,
during strong (weak) economy, supply is too low
(high) than demand. This mismatch between
supply and demand results in greater price
volatility.
o The cost of new supply also increases over time.
Demand for commodities depend on:
Needs of end users which depend on
o Global manufacturing dynamics
o Economic growth
o Government policy
Actions of non-hedging investors
Benefits of Commodities:
6.4.1) Pricing of Commodity Futures Contracts
They provide potentially attractive returns.
They provide inflation hedge because inflation index
levels are determined by commodities prices e.g.
energy and food prices impact the cost of living for
consumers.
They provide diversification benefits as they have
low positive correlation with traditional assets i.e.
stocks and bonds.
Commodity futures contracts may provide higher
liquidity and opportunities to earn a positive real
return.
Risks:
Leverage risk: Leveraged investment in commodities
has high volatility and results in higher risk.
Counterparty risk associated with commodity
derivatives contracts.
NOTE:
When inflation index levels are determined by
commodity prices, then on average, investment in
commodities tend to generate zero return over time.
Investors of commodities: Institutional investors including
endowments, foundations, corporate and public
pension funds, and sovereign wealth funds.
6.4
Reading 60
premiums.
2) Collateral yield: It is the return (i.e. risk-free interest
rate) earned on a fully margined/collateralized
position in a long futures contract (i.e. posting 100%
margin in the form of T-bills).
3) Spot Return/Price Return: It refers to the change in
commodity futures prices that 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.
The spot (or current) prices primarily depend on
current supply and demand.
Returns on a passive investment in commodity futures =
Return on the collateral + Risk premium (i.e. hedging
pressure hypothesis) or the convenience yield net of
storage costs (i.e. theory of storage)
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conditions.
Collectibles can be traded in various ways including
through professional auctioneers, in local flea
markets, online auctions, garage sales, and antique
stores or directly with personal collectors.
Different collectibles indices exist in the market
which provide information about their performance.
However, they may not reliably represent
performance of such asset class.
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8.2
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Risk-Return Measures
Limitations:
Downside risk measures provide incomplete
information because they focus only on losses i.e. left
side of the return distribution curve.
For a negatively skewed distribution, estimating VAR
and shortfall risk using S.D. lead to an
underestimation of downside risk.
In addition, both Sharpe ratio and downside risk do
not consider the low correlation of alternative
investments with traditional investments.
NOTE:
For investors (particularly small investors) with high
liquidity needs, publicly traded securities (i.e. REITs shares,
ETFs shares and publicly traded private equity firms) are
more suitable.
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8.3
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