2. Introduction to Alternative Investments Flashcards
(201 cards)
1
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Alternative Investments
A
real assets, hedge funds, commodities, private equity, and structured products
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Real Assets
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real estate, timberland, infrastructure, intangible assets
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Hedge Funds
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private investment vehicles that capitalize on investment opportunities available as a result of minimal regulatory restrictions
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Commodities
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standardized goods delivered to markets by many producers in large quantities
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Private Equity
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debt and equity securities that are not publicly traded
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Alternative Investment Structured Products
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collateralized debt obligations (CDOs) and credit derivatives
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Diversifiers
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- also called absolute return products
- investments with low or no correlations with traditional assets
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Lumpy Assets
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difficult to divide and can only be traded in certain quantities
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Normal Distribution
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symmetrical bell-shaped distribution defined entirely by the mean and variance
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Methodologies to Analyze Alternative Investments
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- Return computational
- Statistical
- Valuation
- Portfolio Management
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Return Computational Methodology
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- must accommodate the underlying structure
- example: IRR
- prices, div, interest for alts hard to observe, so may not be a good method
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Statistical Methodology
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methods designed to accommodate for non-normal returns
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Valuation Methodology
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use traditional techniques to find mispriced securities but also incorporate alternative investment specific techniques
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Portfolio Management
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special portfolio management techniques are needed to address issues such as liquidity and incorporating higher moments of return distribution.
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Passive Investing
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buying and holding a mix of securities to meet risk and return objectives, which may be expressed as a benchmark
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Benchmark
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standardized measure of performance for an index of portfolios with a certain level of risk and return
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Active Management
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attempt to create better risk and return combinations by actively buying and selling securities
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Absolute Return Standards
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- evaluate investment returns against a standard of zeros or the risk free rate
- goal is to earn return in any market condition
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Relative Return Standards
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evaluate investment return against a benchmark return with the goal of consistently outperforming the benchmark
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Regulatory Structures
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government regulation and taxation
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Securities Structures
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methods of cash flow securitization
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Trading Structures
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development and execution of trading strategies
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Compensation Structures
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organizational and compensation agreements
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Institutional Structures
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financial institutions and markets that affect the ownership and trading of a particular investment
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Buy Side Institutions
asset managers that focus on acquiring appropriate securities for their investment portfolios.
examples: plan sponsor, foundation, endowment, private office, sovereign/non-federal wealth funds, alternative investment funds, separately managed account
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Plan Sponsor
- is an organization that funds a healthcare or retirement plan for qualified member
- responsible for managing plan assets to meet its obligations
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Foundation
- nonprofit fund established for charitable purposes
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Endowment
- fund that is dedicated to providing financial support on an ongoing basis for a specific purpose
- example: university
- long investment horizon, high risk tolerance, little need for liquidity
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Home Office, Private Wealth Institutions
manages the assets of high net individuals
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Sovereign/ Non-Federal Wealth Fund
- pools of assets owned by the government and typically managed by its central bank
- often originate from government surplus or sales of natural resources
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Alternative Investment Funds
- typically structured as limited partnerships
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Separately Managed Account (SMA)
- portfolio that is owned by a single investor and managed according to that investors preferences by an investment advisor
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Sell Side Institutions
- focus on providing investment research and transaction execution services to their customers
- examples: dealer bank, retail broker
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Dealer Bank
- commercial bank that both underwrites and trades investment securities and derivatives.
- JPM, Goldman Sachs, Barclay
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Proprietary Trading
dealer banks that trade for their own account
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Retail Brokers
- provide investment research and execute buy, sell and limit order
- also prop trade
- front, middle and back office
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Front Office
meeting with clients and deciding which investment to buy, sell and hold
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Middle Office
- risk management
| - serving as a communication link between front and back offices
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Back Office
- account maintenance, information technology, and trade clearance and settlement
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Outside Service Providers
- provide professional services that are vital to the formation and continued operation of alternative investment funds
- example: prime brokers, auditors/accountants, attorneys, fund administrators, hedge fund infrastructure, consultants, depositories/custodians, commercial banks
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Prime Broker
executes trades on behalf of an alternative investment manager, lends securities to short sell, provides research data, provides account statements and other documentation, and provides financing for leverage
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Auditors/Accountants
review documentation, provide tax advise, outside audits
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Attorneys
- advise regarding optimal fund structure and maintains regulatory registrations
- documents prepared include: private placement memoranda or offering documents, partnership agreement, subscription agreement, management company operating agreement
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Private Placement Memoranda or Offering Statement
- document given to potential investors and explain the potential trading strategies and associated risks
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Partnership Agreement
- document defines the legal framework for the partnership
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Subscription Agreement
- document determines if a potential investor has sufficient funds to satisfy legal requirements
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Management Company Operating Agreement
- document defines the responsibilities of the limited partnership member and the responsibilities of the fund
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Fund Administrators
- responsible for verifying operational controls, assets under management, and performance figures.
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Hedge Fund Infrastructure
- comprised of three integrated systems: platforms, software, and data providers
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Platforms
operating system that allows the fund mangers to have access to both internal and external data necessary for strategy execution
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Software
computer programs used by the fund that work on its chosen platform
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Data Providers
- such as index and database providers, collect market, fund, and security information and sell it to advisors, institutional investors, consultants, and other investment professionals
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Depositories/Custodians
companies hold client assets and provide information services, trade clearance, and trade settlement
- Depository Trust and Clearing Corporation (DTCC) best know
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Commercial Banks
- assist with capital management, including providing the fund with loans, lines of credit, and external credit enhancement
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Universal Banks
- institutions that allow both commercial banking and investment banking
- commonplace in Germany
- not allowed in US
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Keiretsu
- Japan corporate sturcture
- multiple corporations are linked together via a cross-ownership structure
- large percentage ownership of firm by banks
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Primary Capital Markets
- sale of a new security issue
- securitization
- role of pcm for alts often an exit strategy
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Securitization
assets are pooled together and a new securities are issued that derive their cash flows from the pool's cash flows
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American Depository Receipts (ADRs)
- denominated in US dollars
- traded on US markets
* * represent a claim to foreign stocks
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Global Depository Receipts (GDRs)
- issued outside of the US, and in issuers home country
- not listed on US exchanges
- usually denoted in US dollars
- can be sold to US institutional investors
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Secondary Markets
- where securities trade after their initial issuance
- provide liquidity and value information
- structure: call markets or continuous markets
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Call Markets
- stock is only traded at specific times
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Continuous Markets
- trades occur at any time the market is open
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Bid Ask Spread
- bid price: listed first, price the dealer will pay to buy the security
- ask price: listed second, price at which dealer will sell the security
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Market Making
dealers who determine the bid-ask spread by actively trading in the secondary market and posting buy and sell prices
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Market Orders
customer orders to immediately buy or sell at the best price available
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Market Takers
customers who place market orders, as their orders occur at the stated bid or ask price
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Third Markets
- subset of the OTC market where nonmember investment firms can make markets in and trade exchange listed securities without going through the exchange
- reduces transaction costs
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Fourth Markets
- electronic exchange of securities between investors without using services of broker as an intermediary
- ECN: electronic communication network
- matches orders by crossing
- generally used by institutions, such as pension funds, who deal in very large volumes
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Private Markets
- common for alternatives
| - be aware of lack of transparency and regulation
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Securities Act of 1933
- governs new securities issues
- Regulation D: hedge funds exempt if securities only sold to US accredited investors and securities not marketed to the public
- Regulation S: provides for registration exemptions if both the investment and operations of the fund occur in countries other than the US
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Investment Company Act of 1940
- instituted to regulate investment pools, such as mutual funds
Hedge Fund Exemptions:
- Section 3(c)(1): 100 or fewer investors in the fund
- Section 3(c)(7): all investors in the fund are qualified purchasers and fewer than 500 total
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Investment Advisers Act of 1940
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- require than investment advisors register with SEC
Exemptions:
- small advisor exception
- mid sized advisor exception
- large investment advisor
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Form ADV
- uniform form used by investment advisors to register with SEC
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Churning
illegal excessive trading performed by investment managers in order to earn excess fees from investors
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Soft Dollar Arrangements
investment research, products and services, and cash credits given to the investment manager or broker in return for client business
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Regulation T Margin Rule
- federal reserve rule concerning leverage
| - only 50% of the value of a security can be purchased on margin
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Undertaking for Collective Investment of Transferable Securities (UCITS) Directive
- passed in 1985
| - investment pools created under their guidelines could be more easily market to retail investors
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Markets in Financial Instruments Directive (MiFiD)
- 2007
| - designed to more deeply integrate the financial services of the EU by establishing more uniform regulations
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Dark Pools
non exchange trading systems that do not reveal current client orders
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Alternative Investment Fund Managers (AIFM) Directive
- 2011 (implemented 2013)
- law for those that manage alts in EU
- require fund managers to meet minimum capital requirements and obtain local regulatory approval
- funds covered under UCITS excluded from the law
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Hedge Fund Regulations_ Australia
- HF subject to same regulation as managed funds
| - taxation very complex
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Hedge Fund Regulations_ Brazil
- funds required to adhere to classification claim in investment policy
- regulates investor types, required reporting, and allowable asset valuation methods
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Hedge Fund Regulations_ Canada
- majority of funds are sold using linked products
- must be registered and subject to compliance review
- most can only be sold to accredited investors
- annual disclosure of audits
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Hedge Fund Regulations_ Japan
- minimal regulatory requirements
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Hedge Fund Regulations_ Singapore
- deregulation
- low taxes
- government wants to increase alternatives
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Hedge Fund Regulations_ South Africa
- 2008, fund managers must register
- not allowed to market to retail investors
- HF unregulated
- taxation not yet finalized
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Hedge Fund Regulations_ United Arab Emirates
- HF must register
- funds subject to restrictions and regulations
- no taxation
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Frequency Distribution
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- tabular presentation of statistical data
To construct:
1. Define the intervals
2. Assign the observations
3. Count the observations
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Ex post
returns are historical, or "after the fact"
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Ex ante
returns are future, or "before the fact"
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Ex post returns to predict Ex ante returns
if:
1. distribution is stationary; mean and variance are constant over time
2. large number of historical data
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Normal Distribution
- Gaussian distribution
- bell shaped probability distribution
- mean, median, mode all equal
- asymptotic tails
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Compounding
- growth in value realized on a reinvested asset
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Log Normal Distribution
- Log returns, ln(1 + R) are normally distributed, or equivalently, (1 + R) are log normally distributed
- distribution is continuous
- distributions ranges from -infinity to +infinity
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Autocorrelation
- refers to the correlation among lagged values of a random distribution
- will cause more extreme outcomes than predicted by normal distribution
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Second Central Moment
- variance of the distribution
| - measures the dispersion of the data
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Standard Deviation
- square root of the variance
| - used to measure volatility of the data
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Third Central Moment
- measures the departure from symmetry in the distribution
- will equal zero for symmetric distribution, such as normal distribution
- standardized 3rd central moment = skewness
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Skewness Static
refers to the extent to which the distribution of data is not symmetric about its mean
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Positive Skewness
- tail extends to the right
| - mean > median > mode
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Negative Skewness
- tail extends to the left
| - mean < median < mode
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Fourth Central Moment
- measures the degree of clustering in the distribution
| - standardized 4 central moment = kurtosis
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Kurtosis
- degree of peakedness or clustering in the data distribution
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Excess Kurtosis
- kurtosis for normal distribution equals 3
| - equation: kurtosis - 3
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Mesokurtic
- distribution with zero excess kurtosis
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Leptokurtic
- distribution that has a peak that extends above that of a normal distribution and tails that are fatter than those of a normal distribution
- kurtosis greater than 3
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Platykurtic
- distribution that has a peak that lies beneath that of a normal distribution
- kurtosis less than 3
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Sample Mean
sum of all the values in a population sample, divided by the number of observations in the sample
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Sample Variance
measures the extent to which sampled returns deviate from the sample mean
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Standard Deviation of Normal Distribution
- 68% of the data lie within one standard deviation of the mean
- 95% of the data lie within two standard deviations of the mean
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Homoskedastic
variances of returns are constant over time and independently distributed
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Jarque- Bera
- used to test data for departures from the normal distribution using a null hypothesis and an alternative hypothesis
- also can tests the null hypothesis that the skewness and excess kurtosis jointly equal zero
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Target Semi-Standard Deviation
- focuses solely on return that fall below a pre-specified target return
- downside risk measure
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Shortfall Risk
probability that the investment return will fall below the target
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Tracking Error
- measures the extent to which the investment returns deviate from the benchmark return over time
- quantifies the uncertainty risk regarding deviations of investment returns from the benchmark return
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Drawdown
equals the percentage decline in asset value from its previous high
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Maximum Drawdown
worst percentage loss experienced from peak to trough over a specified period of time
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Value at Risk (VaR)
- measure of potential loss
| - worst possible loss under normal conditions over a specified period of time for a given confidence level
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Conditional VaR
- known as expected shortfall or expected tail loss
- is the loss given that the portfolio return already lies below the pre-specified "worst case" quantile return
- conditional VaR will equal a larger loss than the VaR
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Parametric VaR
calculation that assumes returns are normally distributed
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Monte Carlo VaR
- a model is developed that simulates values for risk factors and estimates how changes in risk factors affect the fund's returns
- model randomly generates possible outcome for the fund
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Heteroskedastic
when variances of financial data are not constant over time
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ARCH
- autoregressive conditional heteroskedasticity
| - used to forecast variances based on recent volatility
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GARCH
- generalized autoregressive conditional
heteroskedasticity
- used to forecast variances based on recent unexpected returns and past variances
- more robust method for forecasting volatility
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Benchmarking
process of identifying the appropriate comparison against which a portfolio's performance is evaluated
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Normative Model
model that attempts to explain how investors SHOULD behave
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Positive Model
model that attempts to explain how investors DO behave
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Theoretical Models
use assumptions and logic that presumably capture underlying investment behavior
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Empirical Models
are based on historically observed behavior
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Applied Models
pragmatic in nature and are designed to address real world problems, such as how to achieve efficient diversification
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Abstract Models
theoretical models designed to describe behavior under hypothetical, unrealistic conditions
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Cross Sectional Models
describe differences across subjects for a single period of time
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Time Series Models
describe differences across time for a single subject
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Panel Data Sets
- refer to data spanning multiple time periods and multiple securities
- combination of cross sectional and time series
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CAPM
- cross sectional equilibrium model that derives the expected return on a stock, given the expected return on the market portfolio, the stock's beta coefficient, and the risk free rate
- expected return on an asset is determined by it systematic risk (beta)
- no additional return will be earned by bearing more idiosyncratic risk
- single factor asset pricing model
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Return Attribution
process of ascribing returns to different components of the asset's performance
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Assumptions of CAPM Valid, Regression Results
- intercept estimate is nor significantly different from zero
- beta estimate equals true beta of asset
- estimates of residuals reflect effects of idiosyncratic risk
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Multi-factor Asset Pricing Model
relationship between expected returns of assets and the assets exposure to multiple risk factors
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Correlation Coefficient
- statistical measure of the linear relationship between two variables
- for assets it measure the strength of the relationship of returns for two assets
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Covariance
- unscaled statistical measure of how two assets move together
- expected value of the product of the deviations of the two random variables from their respective mean value
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Spearman Rank Correlation
```
correlation of the asset returns ranks
Calculated as follows:
1. rank observations
2. compute the differences in the ranks of each paired observation
3. calculate
```
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Autocorrelation
correlation over time for an asset
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Serial Correlation
- first order autocorrelation
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Durbin-Watson
- a statistical test for the existence of serial correlation
- for large samples look at correlation between successive residuals
if = 0, DW= 2: cannot reject null hypothesis
if = 1, DW = 0: reject null hypothesis
if = -1, DW = 4: reject null hypothesis
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IRR
- internal rate of return
- is the discount rate that equates the PV of an investment's cash inflows with the PV of the investments cash outflows
- return associated with a zero new present value
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Lifetime IRR
if all the cash flows are available from start to finish of the investment
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Interim or Since Inception IRR
IRR that assumes an appraised terminal value, period T occurs prior to the end of the investment
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Point to Point IRR
is the IRR if the time 0 and time T cash flows are appraised values or are other cash flows during the investment's lifetime
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Borrowing Type Cash Flow Patterns
time 0 cash flow is positive and the rest of the cash flows are negative
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Multiple Sign Change Cash Flow Patterns
cash flows switch between positive and negative more than once
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Notional Principal
is the face amount on the underlying asset upon which cash flows on a derivative instrument are based
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Cash Waterfall
provision describing how capital is distributed to the fund's investors
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Hurdle Rate
- rate of return that must be distributed to the LP's before general GPss can earn any incentive fees
- typically set between 5-10%
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Soft Hurdle Rate
allows the GP to share in the profits if the performance of the fund is above the hurdle rate
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Hard Hurdle Rate
allows the GP to share only in profits in excess of the hurdle rate
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Carried Interest
is the percentage split of profits the fund managers earn after meeting the minimum hurdle rate and is paid on top of the management fees
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Catch up Provisions
give the GP a larger distribution of the profits upon passing the hurdle rate
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Vesting
denotes the process and timetable by which incentive payments are legally transferred to the GP
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Sharpe Ratio
- equals the expected excess return earned per unit of total risk
- key properties
1. intuitively appealing measure of performance
2. based on total risk
3. sensitive to return computational interval
4. loses usefulness when comparing portfolios with different skew and kurtosis
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Treynor Ratio
- equals the expected excess return earn per unit of systematic risk
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Sortino Ratio
equals the portfolio excess return divided by the target semi-standard deviation
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Information Ratio
- equals the portfolio's excess return divided by the portfolio's tracking error
- active management return divided by the active management risk
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Return on Value at Risk
expected return on the portfolio divided by its value at risk, VaR
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Jensen's Alpha
is the difference between the portfolio mean return and the CAPM ex post mean return
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M^2 Approach
risk adjusted measure of the portfolio return
| - M^2 equals the expected return on the leveraged portfolio that has the same standard deviation as the market index
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Average Tracking Error
difference in mean returns between the portfolio and the portfolio's benchmark
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Return on Value at Risk
expected return on the portfolio divided by its value at risk, VaR
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Jensen's Alpha
is the difference between the portfolio mean return and the CAPM ex post mean return
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M^2 Approach
risk adjusted measure of the portfolio return
| - M^2 equals the expected return on the leveraged portfolio that has the same standard deviation as the market index
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Average Tracking Error
difference in mean returns between the portfolio and the portfolio's benchmark
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Beta
measure of an asset's systematic risk
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Alpha
incremental return earned by an asset relative to the risk adjusted benchmark
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Ex-ante Alpha
anticipated incremental return
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Ex-post Alpha
measure of realized incremental return
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Empirical Analysis of Ex-Ante Alpha
1. Identify appropriate ex post asset pricing model or benchmark
2. Test statistical properties to determine extent to which alpha is attributable to skill
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Test of Skill vs. Luck
- Invalid inferences
- Non-normality
- Sample selection bias
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Beta Nonstationary
refers to the tendency for beta to shift over time
- beta creep
- beta expansion
- market timing
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Beta Creep
gradual increase in beta over time
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Beta Expansion
increases in beta as market conditions change
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Market Timing
attempts of the fund manager to alter beta in anticipation of changes in the market conditions
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Abnormal Return Persistence
tendency for idiosyncratic performance to be positively correlated over time
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Beta Drivers
exposure to market risk factors than compensate investors for bearing non-diversifiable market risk
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Equity Risk Premium
excess return that the market provides above the risk free rate
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Equity Premium Puzzle
tendency of the ERP to exceed its expected value based solely on risk aversion
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Passive Beta Drivers
return drivers form a pure play on bets
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Alpha Drivers
exposure to active return factors
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Product Innovators
are alpha drivers that create new investment opportunities
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Process Drivers
are beta drivers that deliver beta as cheaply and efficiently as possible
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Economic Significance
- describes the extent to which a variable has a meaningful impact
- common error to mistake statistical significance for economic significance
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Type I Error
occurs when rejecting a true null hypothesis
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Type II Error
occurs when failing to reject an untrue null hypothesis
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Bayesian Probability
- equation given on exam
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Data Mining
practice of vigorously testing data until valid relationships are found
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Data Dredging
practice of overusing statistical tests to identify significant relationships with little regard for the underlying economic rationale
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Backfilling
updating databases by inserting returns that pre-date the date of entry
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Chumming
is the fishing term used to describe the process of luring big fish by scattering pieces of cheap bait
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Cumulative Return Charts
- arithmetic scale
| - deceiving
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Cumulative Log Return Charts
- additive
| - better representation of return and volatility over time
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Spurious Correlation
false indication of a true relationship, is coincidental or idiosyncratic, and is limited to the set of observations being examined
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Causality
- one variable at least partly determines the value of another variable
- significant beta does not imply causality
