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CFA Level III > Alternatives > Flashcards

Flashcards in Alternatives Deck (21):
1

Alternative Investments Uses and Features

Used for: diversification and potential for active management

Features

  1. Low liquidity
  2. good diversification
  3. high due diligence costs
  4. difficult to value
  5. Informationally inefficient (requires special skills)

2

Role of different AI in the Portfolio

Unique Risk Factors

Real estate and commodities

Unique Investment Strategies requiring manager skill

Hedge Funds and Mangaged Futures

Blend of Above

Private Equity and distressed equities

3

Due Diligence Checkpoints

Assess the following;

  1. Market opportunity 
  2. Investment process
  3. Service providers (brokers, lawyers, etc.)
  4. Terms/structure of investment
  5. Organization and People
  6. Review & document

4

Special Issues for Private Clients

1. Tax considerations

2. Suitability

3. Communication (client's level of knowledge)

4. Do they understand the risk?

5

Real Estate Types

Types

Direct "equity": residential, commerical, etc - direct management

    Benchmark: NCREIF - quarterly, value-weighted (unlevered)

Indirect: REITS, CREFs (commingled), SMAs, other real estate companies

    Benchmark: NAREIT - cap-weighted REITs, investable (levered)

6

Direct RE Pros/Cons

                   Pros                                              Cons

  • tax-deductible expenses                  High commission/transaction costs
  • allows high leverage                         Each propery is unique
  • direct control                                     High unit costs
  • low return volatility                            Hands on management

 

7

Real Estate Characteristics

  1. Interest rates ^, RE down
  2. + correlation with population
  3. Inflation hedge

CREFs, much better reflection of true RE performance

8

Smoothing

  • Appraisals rely on past data and understate swings in value
  • Appearance of stability: periodic appraisals instead of continuous pricing

9

RE Benchmarks

             NCREIF Index                                   NAREIT Index (REIT)

  • Quarterly reported                               All REITS on NYSE   
  • Value-weighted                                    Cap-weighted
  • Annual appraisals                                 Blend of RE and equity
  • Smoothing (understates volatility)      "Hedged" strips out equity charact.
  • Not investable                                      Investable

10

Private Equity Types

Types

  • Venture capital - investing in private firms (J curve)
    • High failure rate
    • Less cash flows
    • Not leveraged
  • Buyout funds - buy public firm and take private
    • Earlier and steady cash flows
    • Less error in measuring returns
    • Less upside potential

 

11

PE Traits

  • High failure rate
  • Structure/price negotiated
  • Internal (nonpublic) information may be used
  • Involves active role is managing business

12

PE Vocabulary

  • Seed: for market research/ R&D
  • Start-up: pre-revenue to bring idea to life
  • Mezzanine: funding to IPO
  • Angel Investor: first investors
  • VC: specialist providing financing and expertise

13

Private Equity

Direct vs Indirect Investing

  • Direct
    • Convertible Preferred Stock
      • First claim on cash flow and assets
  • Indirect
    • Through LPs or LLCs
      • Provides tax advantages (avoids double tax)
      • GP - selects and manages, plans exit

14

Private Equity

Fee Structures

 

  • Annual base fee: 1.5-2.5%
  • Carried interest fee: incentive fee after investors capital returned
  • Performance fee: % of profits above hurdle rate or preferred return
  • Claw-black: reclaim fees if fund doesn't meet minimum return

15

Private Equity

Issues

  • High risk and return
  • Illiquid
  • Long time horizon, 7+ years
  • Limited information
  • Lack of marketability and control may lower valuations

16

Commodities

Direct vs Indirect Investment

Storable vs Nonstorable

Direct                           Indirect

Cash purchase             Buy companies (mining company)
Long derivatives          Mutual Fund/ETFs

Storable                        Nonstorable

Metal, gold, energy      Agriculture
Inflation hedge             No inflation hedge

17

Commodities

Benchmarks 

Weighting Typpes

1. Based on long only futures contract prices (Dow Jones)
2. Replicable and Investable

 

Two weighting types:

Worldwide production
Perceived worldwide importance

18

Commodities

Return Sources

Formula: Total return = collateral return + spot return + roll return

  • Collateral Yield: known in advance
     
  • Spot Return: ▲ in futures price (Ft - F0)
     
  • Roll Yield
    • (Ft - F0) - (St - S0)
    • Backwardation: F0 < S0          positive roll
    • Contango: F0 > S0                   negative roll

Example: Futures price changed by $6, the spot return is $2, collateral return is $1.

Roll return = 6 - 2 = 4, Total return = 1 + 2 + 4 = 7

19

Managed Futures Traits

Skilled based investment

Uses derivatives markets (futures/options) going long/short

 

20

Hedge Funds

Issues and Concerns

  • investment characteristics change over time
  • survivorship and backfill bias
  • due diligence issues (many are unregulated)

 

  • Understated std (risk) and correlation
  • Overstated Sharpe ratio
  • Infrequency pricing leads to smoothing

 

21

Fund of Funds Pros and Cons

                      Pros                                                          Cons

  • Shortened due diligence process             Double management fees
  • Can replicate a HF index                          Higher change of style drift
  • Diversification