CFA Level I Alternative Investments

Introduction to Alternative Investments

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CFA Level I Alternative Investments

Introduction to Alternative Investments
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Contents and Introduction

1.
2.
3.
4.
5.
6.
7.
8.

Introduction
Alternative Investments
Hedge Funds
Private Equity
Real Estate
Commodities
Other Alternative Investments
Risk Management Overview
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2. Alternative Investments
Traditional investments: long-only positions in stocks, bonds, and cash
Alternative investments: all other investments

General
Characteristics
Of Alternative
Investments

High fees
Low diversification within alternative investments portfolio
High use of leverage
Illiquid; restrictions on redemptions
Narrow manager specialization
Low correlation with traditional investments
Low level of regulation and less transparency
Limited and potentially problematic risk and return data
Unique legal and tax considerations

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Example
As compared to traditional investments, alternative investments tend to be more?

A. Liquid
B. Leveraged
C. Transparent

Solution: B
Alternative investments are often leveraged.

Example 1
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Categories of Alternative Investments

Hedge Funds

Private Equity Funds

Leverage Buyouts
Venture Capital

Real Estate
Residential Property
Commercial Property
Mortgage Backed Securities
Real Estate Investment Trusts (REITs)
Timberland and Farmland

Commodities
Other

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Return: General Strategies

Total return = Alpha return + Beta return

Passive managers assume that markets are efficient and rely only on beta return
Active managers assume that inefficiencies exist and can be exploited
Some managers seek to generate returns that are independent of market returns (absolute
return)
Managers with no limitations on investment categories try to move into higher returning
segments, whereas inflexible managers stick to the restrictions (market segmentation)
Some managers concentrate investments among few securities with the hope of those
securities outperforming market (concentrated portfolios)

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Portfolio Context: Integration of Alternative Investments

with Traditional Investments
Relatively low correlation
between some categories
of alternative
investments and
traditional investments

Relatively high
returns on some
alternative
investment
categories

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Diversification
Benefit

Investment Structures
Partnership is the most common investment structure
Fund is the general partner (GP), usually a limited liability company
Investors are limited partners (LPs)

Funds (GP) charge a management fee based on assets under

management plus an incentive fee based on realized profits

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3. Hedge Funds
Alfred Winslow Jones created a hedged fund in 1949. The purpose of this fund
was to hedge long-only stock portfolio. The fund followed three key tenets:
1. Always maintain short positions
2. Always use leverage
3. Only charge an incentive fee of 20% of profits

Characteristics
of a typical
contemporary
hedge fund:

Aggressively managed portfolio of investments across asset classes and regions

that is leveraged, takes long and short positions, and/or uses derivatives
Goal of generating high returns, either in an absolute sense or over a specified
market benchmark and has few, if any, investment restrictions
Set up as a private investment partnership open to a limited number of investors
willing and able to make a large initial investment
Often imposes restrictions on redemptions

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Hedge Fund Strategies

Hedge Fund Strategies
Event Driven Strategies

Relative Value Strategies

Profit from short-term events Profit from a pricing

that are expected to affect
discrepancy between related
individual companies
securities

Merger Arbitrage
Distressed/Restructuring
Activist
Special Situations

Fixed Income Convertible

Arbitrage
Fixed Income Asset Backed
Fixed Income General
Volatility
Multi-Strategy

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Macro Strategies

Equity Hedge Strategies

Profit from
economic trends
evolving across the
world. Trades are
made based on
expected movement
in economic
variables.

Profit by taking long and

short positions in equity
and equity derivative
securities

Market Neutral
Fundamental Growth
Fundamental Value
Quantitative Directional
Short Bias
Sector Specific

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Example
If Abbacus Hedge Fund identifies undervalued and overvalued firms and takes both
long and positions, which strategy are they employing?

A. Relative value
B. Fundamental value
C. Market neutral

Solution: C

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Hedge Funds and Diversification Benefits

Theory:
Hedge funds can make money regardless of stock market direction
Low correlation with stocks provides diversification benefit

Reality:
Lack of performance persistence
High correlation between stocks and hedge funds between 2003 and
2009

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Hedge Fund Fees and Other Considerations

Common fee structure is 2 and 20 which means 2% management fee and 20% incentive fee
1 and 10 for Funds of Funds
Hurdle Rate
High Water Mark

Hedge funds may use leverage to seek high returns

Generally trade through prime brokers

Redemptions can magnify losses

Redemptions my require hedge fund managers to liquidate positions and incur transaction costs
Drawdowns (decline in NAV) might trigger redemptions
Redemption fees, notice periods and lock-up periods seek to minimize impact of drawdowns
See Example 4: Effect of Redemption

Hedge funds are subject to relatively low regulation

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Example: Fee and Return Calculations

Initial investment is 200 million; fee structure is 2 and 20 and is
based on year-end valuation. In year 1 the return is 30%.
1. What is the total fee if management fee and incentive fee are
calculated separately? What is the investors effective return?
2. What is the total fee if the incentive fee is calculated after
deducting the management fee? Investors net return?
3. If there is a hurdle rate of 5% and fees are based on returns in
excess of 5%, what is the total fee? What is the investors net
return?
In the second year the fund declines to 220 million.
4. Management fee and incentive fee are calculated separately.
A high water mark is used in fee calculations. What is the total
fee? What is the investors net return?
In the third year the fund value increases to 256 million.
5. What is the total fee and investors net return?
Example 2
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Example: Hedge Fund versus Fund of Funds

Hedge Fund H (HFH) has a standard 2 and 20 fee structure. A fund of funds, FOF, has a 1 and 10 fee
structure. In a given year all funds in FOFs portfolio have the same return as HFH. Assume the
management fee is charged based on asset value at the start of the year.
1. Compare the HFH and FOF returns from an investor perspective.
2. Why would an investor invest in a fund of funds?

Example 3
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Example
The hedge fund had an initial investment of $60 million and at the end of first year, value was 70 million
after fees. At the end of the second year, value was 80 million before fees. The fund has 2 and 20 fee
structure and incentive fees are calculated using a high watermark and a soft hurdle rate of 5%.
Calculate the total fee paid for year 2.
A. 2.5 million
B. 3.6 million
C. 4.8 million

Solution: B
Management fee = 80 x 0.02 = 1.6 million
(80-70) x 0.2 = 2 million
Total fee = 1.6 + 2 = 3.6 million

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Hedge Fund Valuation Issues

Hedge funds are generally valued on a daily, weekly, monthly and/or quarterly basis
Value of a hedge fund depends on the value of underlying positions

Market prices

Market prices

Liquid

Illiquid

Mostly (bid+ask)/2 is used

Conservative alternative:
bid price for short and ask
price for long positions

Consider liquidity discount

or haircut
Trading NAV includes
haircut; reporting NAV is
based on quoted prices

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Market prices NOT

available

Estimate value

Example 5

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Due Diligence for Investing In Hedge Funds

Key due diligence points to consider:
Investment Strategy
Investment Process
Competitive Advantage
Track Record (how are returns calculated and reported, what are the fees?)
Size and Longevity
Management style
Key Person Risk
Reputation
Investor Relations
Plans for Growth
System Risk Management
Example 6

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4. Private Equity
Leveraged Buyouts
Venture Capital
Development Capital
Distressed Investing

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Private Equity Structure and Fees

Structured as partnerships
Private equity firm is the General Partner (GP)
Investors are Limited Partners (LPs)

Committed capital

Management fee is 1-3% of committed capital

Incentive fee is typically 20% of total profit

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Private Equity Strategies: Leveraged Buyouts

Acquire companies through significant debt financing. LBOs capital structure comprises of equity, bank
debt and high yield bonds

Two types of LBOs

Target Companies for LBOs

MBO: Current management team

purchases and runs the company
MBI: Current management is
replaced and acquirer team runs
the company

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Undervalued stock price

Willing management
Inefficient companies
Low leverage
Strong and stable cash flow
Lots of physical assets
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Private Equity Strategies: Venture Capital

Invest in private companies (portfolio companies) with significant growth potential
Venture capitalists are actively involved with the companies in which they invest
VC investing can take place at various stages
Formative Stage: Company in the process of being formed
Angel investing: Financing provided at idea stage for sketching out business plan
Seed stage financing: Financing for product development and market research
Early stage: Financing for companies moving towards commercial production
Later Stage Financing: For expansion after commercial production and sales but before IPO
Mezzanine Stage: Preparing to go public

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Example
The stage in which capital is gathered for product development and market research is
called the?

A. Formative stage
B. Seed Stage
C. Early Stage

Solution: B

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Exit Strategies
Ultimate goal of private equity is to improve new or underperforming businesses and
exit them at high valuations; companies held for an average of 5 years

Common exit strategies are:

Trade sale: Selling company to a competition or any strategic buyer
IPO: Company goes public
Recapitalization: Re-leverages itself when interests are low
Secondary sale: Sell to another private equity firm
Write off/Liquidation

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Private Equity: Diversification Benefits, Performance and Risk

May provide higher return relative to traditional investments
Access to private companies
Ability to actively manage and improve portfolio companies
Leverage

Exhibit 10: Comparison of Private Equity and U.S. Stock Returns

Private equity indices rely on self reporting; subject to survivorship, backfill and other biases

Exhibit 11: High Risk

Investors should require higher return for accepting higher risk, including illiquidity risk and
leverage risk

Advice for investors: identify and invest in the best performing private equity funds
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Portfolio Company Valuation

Three approaches to value a portfolio company
1. Market or Comparable
2. Discounted Cash Flow (DCF)
3. Asset Based
Example: A private equity firm is considering buying a firm which produces online educational
content. The firm has EBITDA of 100 million. In the past year four such firms were sold at an
average of 10x EBITDA. What is the estimated value of the firm?

Example 7
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Investment Consideration and Due Diligence

Consider current and anticipated economic conditions
Interest rates and capital availability
Refinancing risk

Long term commitment

Carefully select GP
Due diligence questions similar to what we saw with hedge funds
Evaluating GPs experience and knowledge is critical

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5. Real Estate
Key reasons for investing in real
estate:

Investment characteristics:
Indivisibility

Potential for competitive long term returns

(income and capital appreciation)
Rent from long-term leases will lessen
impact from economic shocks
Diversification

Inflation hedge

Unique characteristics

Fixed location
Operational management
Local markets can be very different from
national or global markets

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5.1 Forms of Real Estate Investment

Private

Debt

Equity

Mortgages

Direct ownership (sole

ownership, JV, real estate
limited partnership, etc.)

Construction Lending

Leveraged ownership
Public

MBS

Shares in REIT corporations

CMO

Shares in real estate investment

trusts

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Real Estate Investment Categories

Residential Property
Investment in residence with intent to
occupy
Leveraged equity

REIT Investing
Mortgage REITs
Equity REITs

Mortgage-Backed Securities (MBS)

Commercial Property
Requires active and experienced
management
Illiquid

Timberland and Farmland

Timberland functions as factory and store
Return drivers: growth, timber price changes, land price
appreciation

Farmland is perceived to provide a hedge against

inflation
Return drivers: harvest quantities, commodity prices,
land price appreciation

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Real Estate Performance and Diversification Benefits

Variety of indices to measure real estate returns
Appraisal index
Repeat sales (transaction-based)
REIT index

Exhibit 15 shows returns of different U.S. Real Estate Indices

Exhibit 16 shows returns of global REITs

During 1990 2009

Correlation of global REITs to global stocks was 0.6
Correlation of global REITs to global bonds was 0.1

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Real Estate Valuation

Common techniques for appraising real estate property:
Comparable Sales Approach
Income Approach
Direct Capitalization
DCF
Cost Approach

REIT valuation:
Income Based: Similar to direct capitalization
Two income measures: Funds from Operations (FFO) and Adjusted FFO (AFFO)
FFO = Net Income + Depreciation gains from sales of real estate + losses on sales of real estate
Asset Based: Calculates REITs NAV = (MV of Total Assets Total Liabilities)/ # of Shares

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Real Estate Investment Risks

Property values are subject to variability based on national and global
economic conditions

Ability to select, finance and manage real estate properties

Expenses may increase unexpectedly
Leverage magnifies risks

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6. Commodities
Commodities are physical products; return depends on price changes only
Generally investment in commodities is through derivative instruments
Futures, forwards, options, swaps, commodity index futures
Contracts may trade on exchanges or over the counter

Other commodity investment vehicles

Exchange traded funds (ETF)
Common stock of companies exposed to a particular commodity
Managed Future Funds:
Similar to hedge funds and are actively managed
Invest in commodity futures and forwards

Individual managed accounts

Specific commodity sectors

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Commodity Performance and Diversification Benefits

Commodities are viewed as a good inflation hedge
Commodity prices impact inflation calculation

Low correlation with traditional investments diversification benefit

Exhibit 18: correlation with global stocks is 0.16
Correlation with global bonds is 0.13

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Commodity Prices and Investments

Commodity spot prices are a function of supply and demand, costs of production,
value to users, and global economic conditions

Future Price Spot Price (1+r) + Storage Costs Convenience Yield

Convenience yield: value associated with holding the physical asset

Futures prices may be higher or lower than spot prices based on convenience yield
Futures price > spot price contango
Futures price < spot price backwardation

Three sources of return for each commodity futures contract

Roll yield
Collateral yield
Spot prices
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7. Other Alternative Investments

Fine art
Fine wine
Rare stamps
Coins
Jewelry
Watches
Sports memorabilia

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8. Risk Management Overview

Investment and risk management process

Both investor and risk manager should be concerned about risk management
Risks vary across alternative investments
Historical returns and standard deviations might be biased
Reported correlations may vary from actual correlations

Traditional risk measures (ex: Sharpe ratio) are not adequate because
asymmetric risk and return profile
Limited transparency
Illiquidity

Due diligence of alternative investment managers is particularly important

Hedge fund and private equity returns depend heavily on fund manager
See Exhibit 20: A Typical Due Diligence Process
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Security Market Indices: Indices for Alternative Investments

Commodity Indices consist of futures contracts on one or more commodities
Performance of index and underlying commodities can be different
Common to have multiple indices with same commodities but in different proportions;
weighting methods also different; different risk return profile
Real estate indices represent market for real estate securities and the market for real estate
Appraisal indices, repeat sales indices, REIT indices

Hedge fund and private equity indices

Constituents determine the index
Poorly performing funds are less likely to report
Index returns overstated due to survivorship, backfill and other biases

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Summary
General characteristics of alternative
investments
Hedge funds
Private equity
Real estate
Commodities
Risk management

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Description
Strategies/sub-categories
Benefits and risks
Fee structures
Due diligence

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Conclusion
Read summary
Review learning objectives
Examples are very good
Practice problems: good but not enough
Practice questions from other sources
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