R30 Alternative Investments Flashcards
1
Q
R30
AI advantages / disadvantages
A
- Low liquidity - therefore higher liquidity premium and returns
- Higher information and diligence costs
- Difficulty of performance evaluation
- Low correlation with traditional asset classes - therefore offer diversification benefits.
2
Q
R30
Real Estate Direct v Indirect
A
- Direct investment - residences, business (commercial) real estate, and agricultural land.
- Indirect investment - RIET’s, company’s that develop and manage real estate, Commingled real estate funds (CREFs), Separately managed accounts, Infrastructure funds (stable returns, low correlation with equity)
3
Q
R30
Real Estate Advantages
A
- Low volatility of returns (Direct investments)
- Low correlation with Equity (Direct investments)
- Good hedge against inflation (Direct investments). Can increase rental rates or leases.
- Tax advantages
- Leverage returns
- Direct real estate investors have direct control over their property and may take action, such as expanding or modernizing, to increase the market value of the property.
- Geographical diversification can be effective in reducing exposure to catastrophic risks (e.g., the risk of hurricanes or floods). The values of real estate investments in different locations can have low correlations; substantial geographical distance is often not necessary to achieve risk reduction benefits.
4
Q
R30
Real Estate Disadvantages
A
- Higher information and transaction costs
- Regulatory risk e.g. tax law changes
- High operating expense
- Cannot subdivide real estate investment
- Large idiosyncratic risk
- Real estate investors are exposed to the risk of neighborhood deterioration, which may be caused by conditions that are beyond the investor’s control.
5
Q
R30
Real Estate: REITs
A
- Reacts to changes to macro economic (inflation etc) environment differently from other asset classes
- More properties will reduce unsystematic (idiosyncratic) risks
- REITs have less unsystematic risks as they have a pool of properties. Have professional management that buy from different geographical locations to generate income to pass on to investors in the form of dividends. Need to meet tax status - 95% of assets in real estate and 90% income to passed on to share holders. Therefore not much capital appreciation.
- Returns from REITs are more aligned with equity markets than the underlining real estate therefore not a good hedge against inflation
- Limited diversification
6
Q
R30
Real Estate Benchmarks
A
- NAREIT > for indirect investment. REIT’s are public companies using financial leverage (therefore assets and liabilities on balance sheet). Use of leverage distorts and makes NARIET less reflective of underlying assets. Cap weighted. Source of valuation are the securities prices for the REITs on the exchange. Index returns calculated after deduction of investment advisory fees.
- NCREIF > for direct investment. Made up of 20 unlevered commercial properties invested into by institutional investors. Smoothed and unsmoothed. Valued by apprasial. However this is not done frequently. This understates volatility, and therefore over estimate risk adjusted returns. This creates a smoothing out bias. Value weighted, published quarterly. Index returns calculated before deduction of investment advisory fees.
- NCREIF unsmoothed > more reflective of current real estate values
7
Q
R30
Hedge Fund: Strategies
A
- Equity market neutral - identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining an equal number of long and short positions. Typically structured to be market, industry, sector, and dollar neutral.
- Convertible arbitrage - buy undervalued convertable bond and short the stock. Benefits if stock volatility increases and credit quality of the issuer improve.
- Fixed-income arbitrage - identify overvalued and undervalued fixed-income securities, primarily on the basis of expectations of changes in the term structure of interest rates or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized.
- Distressed securities - invest in both the debt and equity of companies that are in or near bankruptcy. Long only position. Very illiquid and difficult to short.
- Merger arbitrage - the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company’s stock.
- Hedged equity - identify overvalued and undervalued equity securities. Not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated
- Emerging markets - generally only have long positions.
- Global macro - to take advantage of moves in major financial and non-financial markets through trading in currencies, swaps, futures, and option contracts, although they may also take major positions in traditional equity and bond markets
- Fund of funds - FOF invests in 10–30 hedge funds. Two layers of fees—one to the hedge fund managers and another to the manager of the FOF
8
Q
R30
Hedge Fund Structure
A
- Management Fee - usually 1-2% AUM
- Non mandatory incentive fee - c.20%
- Highwater mark - prevents double dipping, Prevents recouping previous losses as gains.
- Highwater mark is different for each investor based on their subscription date
- Lock-up periods - often invest in risky / illiquid assets that take time to provide required returns. Often 1-3 years. Often withdrawals will take place at certain times (quarterly) to control the outflow of funds so remaining investors should be insulated against the unfavorable unwinding of positions.
9
Q
R30
Fund of Funds Advantages / disadvantages
A
- Diversification benefits - made up of 20-30 hedge funds
- More liquidity
- Less survivorship and back fill bias
- Classification and style drift are issues - Investors must use factors to test for “style drift” in generic FOFs
- FOF needs to keep money aside for redemptions - leads to cash drag
- More correlated to equity markets than hedge funds.
10
Q
R30
Hedge Fund Valuation issues (5)
A
- HF chase absolute return - how to determine benchmark? Most benchmark assume long only positions but HF use both long and short positions
- Impact of performance fees, lockup periods, age of the fund and size of funds on valuation. Young funds outperform older funds, larger fund underperform smaller funds.
- HF returns are calculated monthly as beginning value minus ending value, this is often annualised, but does not consider cash flows. Returns are often smoothed - often use rolling 12 moving average to smooth out variability of returns.
- HF often use leverage. Assets are often consider without leverage.
- HF returns are not normally distributed - Sharpe Ratio is not appropriate.
11
Q
R30
Sharpe Ratio limitations
A
- Assumes normal distributions - but HF returns not normally distributed.
- Assumes all asset are all liquid. Illiquidty assets are not valued frequency which underestimates volatility - bias SR upwards.
- The Sharpe ratio has not been found to have predictive ability for hedge funds in general.
- The Sharpe ratio is primarily a risk-adjusted performance measure for stand-alone investments and does not take into consideration the correlations with other assets in a portfolio.
- The Sharpe ratio can be gamed:
- Lengthening the measurement interval. This will result in a lower estimate of volatility;
- Compounding the monthly returns but calculating the standard deviation from the uncompounded monthly returns
- Writing out-of-the-money puts and calls on a portfolio. This strategy can potentially increase the return by collecting the option premium without paying off for several years
- Smoothing returns.
- Getting rid of extreme returns (best and worst monthly returns each year) that increase the standard deviation. Operationally, this strategy entails a total-return swap
12
Q
R30
Hedge Fund Benchmarks
A
- Hedge Fund Research (HFR) big index for HF
- Issues:
- Relevance of past data - the past returns of an index reflect the performance of a different set of managers from today’s or tomorrow’s set. may be a more severe problem for value-weighted indexes than for equal-weighted indexes because value-weighted indexes are more heavily weighted in the recent best-performing fund(s)
- Popularity bias - As top-performing funds grow through new inflows and high returns and poorly performing funds are closed, the top-performing funds represent an increasing share of the index
- Stale price bias - lack of security trading - measured standard deviation may be higher or lower than it would be if actual prices existed. Not a big issue for HF.
- Backfill bias - missing past return data for a component of an index are filled in at the discretion of the component
- Survivorship bias -this bias is in the range of at least 1.5%–3% per year. Minor for event-driven strategies, is higher for hedged equity, and is considerable for currency funds.
13
Q
R30
Commodities General
A
- Direct - buy physical commodity or derivative on commodity. Low correlation with equity and bonds. May incur carrying costs.
- Indirect - equity in companies specializing in commodity production. Indirect commodity investment—in particular, equity instruments in commodity-linked companies—does not provide effective exposure to commodity price changes. Especially if company is hedge its risk.
- Commodities often have postive correlation with inflation (except agriculture)
- Commodity indices wieghted on world production or worldwide importance of that commodity.
14
Q
R30
Commodities and inflation
A
Two factors making a commodity a good hedge against unexpected inflation:
- Storable
- Demand for commodity is linked economic activity.
15
Q
R30
Determinants of commodity returns (3)
A
- Business cycle–related supply and demand - supply and demand conditions are determined by different economic fundamentals from those affecting stocks and bonds, commodity prices are expected to be sensitive to the business cycle but to have little or even negative correlation with stocks and bonds. 3 reasons for this:
- Commodities correlate positively with inflation whereas stocks and bonds are negatively correlated with inflation.
- Commodity prices and stock/bond prices react differently in different phases of the business cycle. Commodity futures prices are more affected by short-term expectations, whereas stock and bond prices are affected by long-term expectations.
- Commodity prices tend to decline during periods of weakness in the economy.
- Convenience yield. - At low inventory levels, convenience yields are high, and vice versa. A related implication is that the term structure of forward price volatility generally declines with the time to expiration of the futures contract—a phenomenon known as the Samuelson effect.
- Real options under uncertainty - producers are holding valuable real options—options to produce or not to produce—and will not exercise an option to produce unless spot prices start to climb.
