Alternative Investments Flashcards
Types of Alternative Investments
- Private Equity
- Hedge funds
- Private Credit
- Commercial Real Estate
- Real Assets
Roles of Alternative Investments in a Portfolio
4 Main Functional Roles in a Portfolio:
* Capital growth
* Income generation
* Risk diversification
* Safety
Are Alternative Investment or Bonds Better to Diversify a Portfolio?
It depends on the time horizon:
* Shorter: Primary risk factor is return volatility diversify with Bonds
* Longer: Primary risk failure to achieve the target investment goal diversify with Private Equity
Traditional Approach Advantages vs Disadvantages
Investment Opportunity Set:
* Liquidity-Based Approach: Distinguish between private and publicly traded investments
* Economic Environment Based Approach: Classify assets classes performance on growth and inflation
Advantages:
* Describes the roles of asset class intuitively
* Easier to communicate with decision makers
* Lower overhead costs
* Better for less sophisticated people
Disadvantages:
* Overestimate diversification
* Obscure the primary drivers of risk
Risk Factor-Based Approach Advantages vs Disadvantages
“Non-Traditional” Estimating asset class sensitivity to specific risk factors
Advantages:
* Identify sources of risk that are common across the separate asset classes
* Not as exposed to different asset classes with the same risks factors
* Develops and integrates a risk management framework
Disadvantages:
* May be sensitive to the time period used
* Results can be hard to discuss, communicate, and implement
* Converting risk-factor targets into investment mandates whilst incorporating liquidity planning, rebalancing ranges, and manager selection can be challenging.
Alternative Investments Issues
- Liquidity issues
- Valuations issues
- Asymmetrical returns
- Old Prices
- Lagging/Appraisal Values
- Returns can be lower negative in drawdowns periods and high in later periods
- We cannot always assume that returns will be normally distributed (right or left skewed)
Investment Vehicles of Alternative Investments
- Limited Partnership
- Fund of Funds (FOF)
- Separately managed accounts (SMAs)/Funds of one
- Mutual funds and UCITS (undertakings for collective investments in transferable securities)
Side Pocket
A fund might designate some of the funds to less liquid funds not subjected to the funds ordinary redemption returns because these investment might have larger returns in the future.
Expense Fees and Taxes of Alternative Investments
Usual Fees:
* 20-2 Fee Structure: General Partner have a 2% management fee and a 20% gross profit fee if profitable
* Many will have significant expenses (administrative) that need to be pass down to the limited partners
Funds with Call Down Structures:
* Will charge management fees on the amount of committed capital.
* Might generate negative returns for the limited partners in the earlier years.
Major Issues Inherent in Alternative Assets Returns Data
Issues:
* Smoothing of returns due to appraisal-based valuations
* Stale or Infrequent Pricing
* Non-normal returns.
To Address these Issues:
* Unsmooth the alternative asset class returns where appropriate.
* Determine whether normality is a reasonable assumption for the returns.
* Adjust optimization techniques to account for the non-normal returns
Approaches of Asset Allocation for Alternative Investments
3 Primary Approaches:
1. Monte-Carlo Simulation
2. Mean-Variance Optimization (MVO)
3. Risk-Factor-Based Approaches
Drawbacks of Applying MVO to Alternative Assets
There are 2 Major Drawbacks:
* MVO, is based purely on return and standard deviation, is likely to over-allocate to private illiquid investments subject to smoothing and ignore illiquidity issues.
* Uses volatility as a risk measure, which ignores the higher moments of a distribution such as skewness and kurtosis.
Risk-Factor-Based Optimization
- Asset allocation can be conducted based on a portfolio’s exposure to risk factors rather than to individual asset classes.
- Using the expected returns, volatilities, and correlations of these risk factors, an analyst can establish optimal risk-factor exposure given the objectives and constraints.
Issues Include:
* Differing investor risk-factor descriptions
* Return correlations
* Sensitivity stability
Liquidity Planning for Alternative Investments
Managing liquidity is important in any alternate program:
* Can develop forecasting model to help manage liquidity
* Distributions can also be model from its NAV
* Can estimate cash flows coming in and going out
* Having cash available to meet the capital calls
* Instead of money market funds the uncalled capital could be invested into public investments proxies
Monitoring Alternative Investment Programs
- Monitor returns, safety provisions, and risk assumed.
- Cannot compute to a passive benchmark
- Can create a normalized portfolio to compare their returns
- Reported process is voluntary and can be at a lag as there is not set schedule.
- Use an IRR rather than a time weighted return (GIPS)
- IRR can be significantly influenced by the investors by adding funds, capital calls, and distributions.
- Investors might prefer to monitor a private funds Multiple on Invested Capital (MOIC)
Issues with Alternative Funds Management
- Management interest should be aligned with investors
- Look at the profile of the other investors in the funds
- Increase in redemption from other investors
- Large influx of newer partners
Major Hedge Fund Categories Strategies
Equity Related Strategies: Focus on Stocks
* Long-Short Equity
* Dedicated Short-Bias
* Equity Market Neutral
Event Driven: For corporate actions
* Merger Arbitrage
* Distressed Securities (can be equity or debt)
Relative Value: Profit from difference between 2 securities
* Fixed-Income Arbitrage
* Convertible Bond Arbitrage
Opportunistic: Top-down approach
* Global Macro
* Managed Futures
Specialist: Require market knowledge or expertise
* Volatility: Buy and selling contracts on the VIX futures
* Reinsurance
Multi-Managers: Other hedge funds strategies
* Multi-Strategy Funds: Open to retail investors
* Fund of Funds
Key Features that Distinguish Hedge Funds from Traditional Investments
- Lower Regulations and Legal Constraints
- Large Investment Universe
- Great Flexibility for Short Selling and/or Derivatives
- Will be able to get an aggressive investment exposure
- Constraints for Liquidity
- Lack of Transparency
- Higher Cost Structure
- Some asset Managers look to invest in these hedge fund strategies for alpha (excess returns)
- A way of accessing top investment talent
Arguments Against Hedge Funds from Traditional Investments
- High internal fund costs associated with complex structures
- Need to understand complex offering documents
- Lack of investment transparency/return attribution
- Longer-lived investment commitments
- Lockups or limited investment redemption periods
Difference Between Long-Short and Equity Market Neutral
- Look at the universe of companies and create pockets of difference industries to create a very well diversified portfolio to create pairs trading.
- Long one undervalued stock and short an overvalued stock in the same industry
- It will eliminate market risk but still have idiosyncratic risk.
- Long-short does not have to have an exact number of long or short position it can be net either one
- Equity market neutral must have an equal number of positions.
Long-Short
Long positions in stocks they think will rise and short position in stocks they think that will decline:
* The resulting portfolio will have a Beta (market exposure)
* Does not try to eliminate the market exposures entirely
* Payment to provide return comparable to a long-only fund, but with less volatility and risks.
* The majority take a specific sector focus in industry they are familiar with
* Investment worthwhile for the fees of a long only strategy
