Reading 24 Alternative Investments Portfolio Management

Question 1

If managed futures strategies are often momentum based, how do they achieve excess returns differently from traditional stock or bond investment vehicles?

Answer 1

The theory of market efficiency suggests that news is simultaneously available to all market participants and is quickly incorporated into market prices. However, research in behavioral finance indicates that investors may systematically underreact to information; consequently, security prices may trend, particularly in traditional investment vehicles (stocks and bonds). Actively managed derivative strategies that follow momentum, or trend-based, models have been shown to be profitable by capturing these trends.

Question 2

Due diligence in PE

Answer 2

Among the major requirements for private equity investing is careful due diligence.

Due diligence items for private equity can usually be placed into one of the following three bins:

1. Evaluation of prospects for market success.

• Markets, competition, and sales prospects. This review includes an evaluation of markets, competition, and sales prospects.
• Management experience and capabilities. Quality of management is often considered the single biggest factor in the success of a venture.
• Management’s commitment. Much of the success of a private equity company depends on its managers. Therefore, a potential investor will want to gauge how committed the managers are to the company. There are several factors to use in assessing this:
  
  • Percentage ownership.
  • Compensation incentives.
• Cash invested. How much cash or “skin” has management invested in the company?
• Opinion of customers.
• Identity of current investors.

2. Operational review, focusing on internal processes, such as sales management, employment contracts, internal financial controls, product engineering and development, and intellectual property management.

• Expert validation of technology.
• Employment contracts.
• Intellectual property.

3. Financial/legal review, including the examination of internal financial statements, audited financial statements, auditor’s management letters, prior-year budgets, documentation of past board of directors meetings, board minutes, corporate minute books, and assessment of all legal proceedings, intellectual property positions, contracts and contingent liabilities.

• Potential for dilution of interest.
• Examination of financial statements.

Fund selection is largely an exercise in evaluating the capabilities of the general manager’s management team. Factors that should be considered include the following:

• historical returns generated on prior funds;
• consistency of returns. Has the team had one successful fund or many?
• roles and capabilities of specific individuals at the fund. The investor will want to evaluate whether the fund manager has the needed human resources to effectively select and guide private equity investment;
• stability of the team. Did the current senior personnel generate the track record of the fund manager, or has there been significant personnel turnover?

Question 3

Returns of Hedge Funds

Answer 3

Hedge funds typically report data to hedge fund data providers monthly, and the default compounding frequency for hedge fund performance evaluation and reporting is monthly.

The reporting and compounding frequency can materially affect hedge funds’ apparent performance for a number of reasons, including the following:

• Many hedge funds allow entry or exit to their funds quarterly or even less frequently.
• In calculating drawdowns, no compounding is typically applied to the loss.

The issues of leverage and the use of derivatives in return calculation also arise in hedge fund performance evaluation. The calculation convention followed in the hedge fund industry is to “look through” the leverage as if the asset were fully paid. Thus, as the beginning value in the above equation for rate of return, the return on a levered position is based on the amount actually paid plus any borrowing used to fund the purchase. The ending value is, of course, calculated on a consistent basis. Thus, leverage affects the weighting of an asset in the portfolio but not the return on the individual asset. The same principle of deleveraging applies to the computation of the rate of return when derivatives are included in the hedge fund portfolio.

Investors sometimes examine the rolling returns to a hedge fund. The rolling return, RR, is simply the moving average of the holding-period returns for a specified period (e.g., a calendar year) that matches the investor’s time horizon.

Question 4

Historical Performance for Distressed Securities

Answer 4

Return distribution for distressed securities is distinctly non-normal. In particular, it reflects significant downside risk, with a negative skewness. The negative skewness indicates that, for distressed securities, large negative returns are more likely than large positive returns. Hence, there is a bias to the downside. In addition, the monthly return distribution displays a large degree of kurtosis. This indicates that these securities are exposed to large outlier events. The two statistics together indicate significant downside risk.

Consequently, the Sharpe ratio, which is based on the normal distribution assumption, may not capture the complete risk–return trade-off of distressed securities investing.

Question 5

Types of Hedge Fund Investments

Answer 5

1. Equity market neutral: Equity market-neutral managers attempt to identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining long and short positions. Portfolios are typically structured to be market, industry, sector, and dollar neutral. This is accomplished by holding long and short equity positions with roughly equal exposure to the related market or sector factors. The market opportunity for equity market-neutral programs comes from 1) their flexibility to take short as well as long positions in securities without regard to the securities’ weights in a benchmark and 2) the existence of pockets of inefficiencies (i.e., mispricing relative to intrinsic value) in equity markets, particularly as related to overvalued securities. Because many investors face constraints relative to shorting stocks, situations of overvaluation may be slower to correct than those of undervaluation.
2. Convertible arbitrage: Convertible arbitrage strategies attempt to exploit anomalies in the prices of corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds’ risk by shorting the associated stock. The cash proceeds from the short sale remain with the hedge fund’s prime broker but earn interest, and the hedge fund may earn an extra margin through leverage when the bonds’ current yield exceeds the borrowing rate of money from the prime broker. The risks include changes in the price of the underlying stock, changes in expected volatility of the stock, changes in the level of interest rates, and changes in the credit standing of the issuer. In addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies typically make money if the expected volatility of the underlying asset increases or if the price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make money if the credit quality of the issuer improves.
3. Fixed-income arbitrage: Managers dealing in fixed-income arbitrage attempt to 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 against directional market movements because the portfolios combine long and short positions.
4. Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Distressed debt and equity securities are fundamentally different from nondistressed securities. Most investors are unprepared for the legal difficulties and negotiations with creditors and other claimants that are common with distressed companies. Traditional investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many investors are prevented by charter from holding securities that are in default or at risk of default. Because of the relative illiquidity of distressed debt and equity, short sales are difficult, so most funds are long.
5. Merger arbitrage: Merger arbitrage, also called “deal arbitrage,” seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In 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.
6. Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated. For example, the value of short positions may be only a fraction of the value of long positions and the portfolio may have a net long exposure to the equity market. Hedged equity is the largest of the various hedge fund strategies in terms of assets under management.
7. Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major financial and nonfinancial markets through trading in currencies, futures, and option contracts, although they may also take major positions in traditional equity and bond markets. For the most part, they differ from traditional hedge fund strategies in that they concentrate on major market trends rather than on individual security opportunities. Many global macro managers use derivatives, such as futures and options, in their strategies. Managed futures are sometimes classified under global macro as a result.
8. Emerging markets: These funds focus on the emerging and less mature markets. Because short selling is not permitted in most emerging markets and because futures and options are not available, these funds tend to be long.
9. Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10–30 hedge funds, and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees—one to the hedge fund manager, and the other to the manager of the FOF.

Question 6

Other Performance Issues of Hedge Funds

Answer 6

1. Young funds outperform old funds on a total-return basis, or at least old funds do not outperform young ones;
2. On average, large funds underperform small funds;
3. FOFs may provide closer approximation to return estimation than indices do.

• Performance fees and lock-up impacts. Periods of severe drawdown (e.g., 1998) may influence funds to dissolve rather than face the prospect of not earning the incentive fees because of HWM provisions. There is some evidence of an impact of lock-up periods on hedge fund performance. In the case of US hedge funds, funds with quarterly lock-ups have higher returns than similar-strategy funds with monthly lock-ups.
• Funds of funds. FOF returns may differ from overall hedge fund performance because of various issues, including a less direct impact of survivorship bias on FOFs because hedge funds that dissolve are included in the returns of the FOFs (there still is some survivorship bias, in that FOFs may remove themselves from datasets because of, for example, poor performance). FOFs may thus provide a more accurate prediction of future fund returns than that provided by the more generic indices. However, classification and style drift are issues with FOFs. A number of FOFs reported as diversified by category differ greatly not only in their correlation with standard indices but also in their sensitivity to general economic factors. Investors must use factors to test “style drift” of generic FOFs.
• Effect of fund size. On the one hand, there are potential advantages to a hedge fund having a large asset base. The fund may be able to attract and retain more talented people than a small fund and receive more attention from, for example, its prime broker. On the other hand, a smaller fund may be more nimble. Research has generally supported the conclusion that, overall, larger funds have earned lower mean returns and lower risk-adjusted returns than small funds.
• Age (vintage) effects. It may be difficult to compare the performance of funds with different lengths of track record. Comparisons of a fund with the performance of the median manager of the same vintage in a hedge fund’s style group can be revealing.

Question 7

Colleteral return with respect to a commodity futures contract?

Answer 7

Represents the return on a fully hedged commodity position which should be approximately the risk-free rate.

The colleteral return is the result of the no-arbitrage that if an investor is long a contract and invests an amount in T-bills that will be equal to the amount required to pay for the required purchase at the maturity of the futures contract. Such a fully-hedge position should earn the risk-free rate.

Question 8

Diversifiaction is one of the major issues that must be addressed when formulating a private equity investment strategy. To be considered diversified, investors must be able to invest in 5 to 10 different investments. In order to do this investors must typically have portfolios of at least?

Answer 8

Investors typically need to have portfolios of at least $100 million in order to be able to invest in 5 to 10 different investments and be considered diversified though a number of positions.

Question 9

Historical Performance of Private Equities

Answer 9

Private equity returns have exhibited a low correlation with publicly traded securities, making them an attractive addition to a portfolio. However, because of a lack of observable market prices for private equity, short-term return and correlation data may be a result of stale prices.

Question 10

Contrast the characteristics of two managed futures styles: systematic and discretionary

Answer 10

Systematic trading strategies are rule based and frequently trend following. Discretionary trading strategies rely on portfolio manager judgment rather than rules and include strategies based on fundamental economic data and trader beliefs.

Question 11

Which absolute-return hedge fund strategy to which managed futures are mostly closely related (i.e., managed futures are often considered a subgroup of this hedge fund strategy)?

Answer 11

Managed futures are often considered a subgroup of global macro hedge funds because both strategies attempt to take advantage of systematic moves in major financial and nonfinancial markets

Question 12

Benchmarks for distressed securities

Answer 12

In the context of hedge funds, distressed securities investing is often classed as a substyle of event-driven strategies.

Question 13

Types of Private Equity Investment

Answer 13

1. Direct venture capital investment is structured as convertible preferred stock rather than common stock. The terms of the preferred stock require that the corporation pay cash equal to some multiple (e.g., 2×) of preferred shareholders’ original investment before any cash can be paid on the common stock, which is the equity investment of the founders. Investors in subsequent rounds usually have rights to cash flows that are senior to preferred stock issued in previous financing rounds.
2. The limited partnership and LLC forms are attractive because income and capital gains flow through to the limited partners (for the LLC, the shareholders) for tax purposes, thus avoiding the possible double taxation that can occur in the corporate form. The LLC form, available in the United States and some other countries under different names and with different requirements, is a hybrid of the corporate and partnership forms.
3. Private equity funds of funds are also available. Such funds invest in other private equity funds. Management fees of funds-of-funds vehicles range from 0.5 percent to 2 percent of the net assets managed; these fees are on top of fees charged by the underlying funds. In contrast to the structure of private equity funds, in venture capital, the company receiving support is organized in a corporate form because one desirable exit is a successful initial offering of shares to the public.

Question 14

Interpretation Issues of Historical Performance of Hedge Funds

Answer 14

The hedge fund investor should be aware of the following issues in selecting and using hedge fund indices.

1. Biases in Index Creation

• Value weighting may result in a particular index taking on the return characteristics of the best-performing hedge funds in a particular time period: As top-performing funds grow from new inflows and high returns and poorly performing funds are closed, the top-performing funds represent an increasing share of the index.
• Equal-weighted indices may reflect potential diversification of hedge funds better than value-weighted indices. For funds designed to track equal-weighted indices, however, the costs of rebalancing to index weights make it difficult to create an investable form.

2. Relevance of Past Data on Performance

• The best forecast of future returns is one that is consistent with prior volatility, not one that is consistent with prior returns.

3. Survivorship Bias

• Survivorship bias results when managers with poor track records exit the business and are dropped from the database whereas managers with good records remain. If survivorship bias is large, then the historical return record of the average surviving manager is higher than the average return of all managers over the test period.
• Survivorship bias is minor for event-driven strategies, is higher for hedged equity, and is considerable for currency funds. More importantly, for the largest hedge fund group, equity hedge funds, overestimation of historical performance because of survivorship bias has been previously reported to range from 1.5 percent to 2 percent. However, the bias may be concentrated in certain periods.
• One explanation for the proliferation of FOFs is that managers of these funds may be able to avoid managers destined to fail, thereby mitigating the survivorship bias problem. Investors may be willing to bear an additional layer of management fees to reduce exposure to the ill-fated managers.

4. Stale Price Bias

• In asset markets, lack of security trading may lead to what is called stale price bias. For securities with stale prices, measured correlations may be lower than expected, and depending on the time period chosen, measured standard deviation may be higher or lower than would exist if actual prices existed.

5. Backfill Bias (Inclusion Bias)

• Backfill bias can result when missing past return data for a component of an index are filled at the discretion of the component (e.g., a hedge fund for a hedge fund index) when it joins the index. As with survivorship bias, backfill bias makes results look too good because only components with good past results will be motivated to supply them.
• A variation of the survivorship bias that results from inclusion of a new hedge fund into a given index and its past performance is ‘backfilled’ into the index’s database. In other words, this bias occurs when the performance of a fund is added to database listings months or even years after inception.

Question 15

Ray McQueen, CFA, invests in natural gas futures for the Horizon Energy Fund. The natural gas markets are in contango. McQueen lengthened the average maturity of the futures contracts in his portfolio. McQueen MOST LIKELY extended the maturity to:

a) Increase the correlation of the futures to stocks and bonds.
b) Take advantage of the positive roll return.
c) Decrease the forward price volatility.

Answer 15

The Samuelson effect predicts that forward price volatility will decrease with increasing maturity. Short maturity contracts exhibit greater price volatility because of near-term mismatches between supply and demand. Over time, these mismatches balance out, leading to less price volatility in long maturity contracts.

Choice “a” is incorrect. The correlation of natural gas futures to stock and bonds prices depends on the underlying correlation of natural gas with stocks and bonds. Extending the maturity of the futures contract should not affect the correlation.

Choice “b” is incorrect. An investor can earn a positive roll return when a futures market is in backwardation, which allows the investor to purchase less expensive, longer-term contracts as more expensive, near-term contracts expire. McQueen faces a natural gas futures market in contango.

Question 16

Commodity Index Return Components

Answer 16

• A commodity futures investor needs to understand, in particular, how the returns on a futures contract-based commodity index are calculated. The returns have three components: the spot return, the collateral return, and the roll return.
• The spot return or price return is calculated as the change in the spot price of the underlying commodity over the specified time period.
• Collateral return or collateral yield comes from the assumption that the full value of the underlying futures contract is invested to earn the risk-free interest rate—that is, that an investor long a futures contract posts 100 percent margin in the form of T-bills (in such a case the futures position is said to be fully collateralized). The implied yield is the collateral return.
• Roll return or roll yield arises from rolling long futures positions forward through time.
• A monthly roll return is computed as the change in the futures contract price over the month minus the change in the spot price over the month. The closer the futures contract is to maturity, the greater the roll return/yield is.
• When the futures markets are in backwardation, a positive return will be earned from a simple buy-and-hold strategy. The positive return is earned because as the futures contract gets closer to maturity, its price must converge to that of the spot price of the commodity. Because in backwardation the spot price is greater than the futures price, the futures price must increase in value. (The opposite is true with an upward-sloping term structure of futures prices, or contango.) All else being equal, an increase in a commodity’s convenience yield (the nonmonetary benefit from owning the spot commodity) should lead to futures market conditions offering higher roll returns; the converse holds for a decline in convenience yields.

Question 17

Hedge Fund Due Diligence

Answer 17

Although hedge funds typically provide an annual audited financial statement and performance review, they rarely disclose their existing portfolio positions. Possible concerns that arise from this lack of disclosure include the following:

• Authenticity of the hedge fund manager’s performance is doubtful if investors cannot verify the performance with a position report.
• Risk monitoring and management are difficult for investors without disclosure of trading and portfolio positions by the hedge fund manager. Without full disclosure of the holdings, investors cannot aggregate risk across their entire investment program to understand the implications at the portfolio level.

! The fund`s research strategy and expenditures are key to understanding how the fund operates

Question 18

Which stage of financing generally supports futher expansion of production and sales?

Answer 18

The second stage of financing supports futher expansion of production and sales. The third stage of financing typically can support additional major expansion. First stage is used to begin manufacturing and sales.

Question 19

Types of Managed Futures Investments

Answer 19

In addition to private commodity pools, managed futures programs are also available in separately managed accounts (sometimes known as “CTA managed accounts”). Publicly traded commodity funds open to smaller investors are also available. Managed futures programs may use a single manager or multiple managers.

Managed futures may be classified according to investment style. They are often classified into subgroups on the basis of investment style (e.g., systematic or discretionary), markets traded (e.g., currency or financial), or trading strategy (e.g., trend following or contrarian). Managed futures are at times viewed as a subset of global macro hedge funds, in that they also attempt to take advantage of systematic moves in major financial and nonfinancial markets, primarily through trading futures and option contracts.

The trading strategies of managed futures include the following:

• Systematic trading strategies trade primarily according to a rule-based trading model usually based on past prices. Most systematic CTAs invest by using a trend-following program, although some trade according to a contrarian, or countertrend, program. In addition, trend-following CTAs may concentrate on short-term trends, medium-term trends, long-term trends, or a combination thereof.
• Discretionary trading strategies trade financial, currency, and commodity futures and options. Unlike systematic strategies, they involve portfolio manager judgment. Discretionary trading models include those based on fundamental economic data and on trader beliefs. Traders often use multiple criteria in making trading decisions.

By the markets emphasized in trading, managed futures may be classified as:

• Financial (trading financial futures/options, currency futures/options, and forward contracts).
• Currency (trading currency futures/options and forward contracts).
• Diversified (trading financial futures/options, currency futures/options, and forward contracts, as well as physical commodity futures/options).

Question 20

The Supply of Venture Capital and Private Equity

Answer 20

• Angel investors. An angel investor is an accredited individual investing chiefly in seed and early-stage companies, sometimes after the resources of the founder’s friends and family have been exhausted.
• Venture capital. Venture capital (VC) refers broadly to the pools of capital managed by specialists known as venture capitalists who seek to identify companies that have great business opportunities but need financial, managerial, and strategic support. Venture capitalists invest alongside company managers; they often take representation on the board of directors of the company and provide significant expertise in addition to capital. An individual pool is a venture capital fund (VC fund). An industry of investment firms sponsors series of such funds and sometimes a variety of similarly structured vehicles taking advantage of different opportunities. These firms may be private partnerships, closely held corporations, or sometimes, publicly traded corporations. In the United Kingdom, venture capital trusts (VCTs), which are exchange-traded, closed-end vehicles, provide an example of other opportunities that are available.
• Large companies. A variety of major companies invest their own money via corporate private equity in promising young companies in the same or a related industry. The activity is known as corporate venturing, and the investors are often referred to as “strategic partners.” Corporate venturing funds are not available to the public.
• Most investors participate in private equity through private equity funds. Among these funds, buyout funds constitute a larger segment than VC funds, as measured by assets under management or the size of capital commitments. Mega-cap buy-out funds take public companies private. Middle-market buy-out funds purchase private companies whose revenues and profits are too small to access capital from the public equity markets. The buyout fund manager seeks to add value by:
  
  • restructuring operations and improving management;
  • opportunistically identifying and executing the purchase of companies at a discount to intrinsic value; and
  • capturing any gains from the addition of debt or restructuring of existing debt.
• Buyout funds can realize value gains through a sale of the acquired company, an IPO, or a dividend recapitalization. A dividend recapitalization involves the issuance of debt to finance a special dividend to owners (sometimes refinancing existing debt in the process).

Question 21

VC funds and buyout funds have some expected differences in return characteristics

Answer 21

VC funds and buyout funds have some expected differences in return characteristics.

• Buyout funds are usually highly leveraged.
• The cash flows to buyout fund investors come earlier and are often steadier than those to VC fund investors. The expected pattern of interim returns over the life of a successful venture capital fund has sometimes been described as a J-curve, in which early returns (e.g., over the first five or six years) are negative as the portfolio of companies burns cash but later returns accelerate as companies are exited.
• The returns to VC fund investors are subject to greater error in measurement.

Question 22

With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of?

Answer 22

Both the extra layer of fees and the higher liquidity offered.

FOF are usually considered good choices for individual investors because they offer diversification and usually more liquid. One problem with FOF is that they usually have lower returns. This is a result from both the additional layer of fees and cash drag resulting from a desire to have higher liquidity).

Question 23

Size of the Real Estate Market

Answer 23

Estimates have been made that real estate represents one-third to one-half of the world’s wealth, although figures are hard to document.

Question 24

Financing stages through which many private companies pass

Answer 24

The financing stages through which many private companies pass include the following:

Early-Stage Financing

• Seed—generally, seed money is a relatively small amount of money provided to the entrepreneur to form a company and prove that an idea has a reasonable chance of commercial success.
• Start-up—at this stage, the company has been formed and an idea has been proven but the company needs money to bring the product or idea to commercialization. This is a pre-revenue stage.
• First stage—if the company has exhausted its seed and start-up financing, the company may seek additional funds. Obviously, the company must have made progress from earlier stages to warrant an investment at this stage.

Later-Stage Financing:

• This is the financing of promising companies that need funds for expanding sales.

The Exit

Because private equity is by definition not publicly traded, the exit (the liquidation or divestment of a private equity investment) is often difficult and is a major item of strategy. The investor can realize the value of the holding in several ways:

• merger with another company;
• acquisition by another company (including a private equity fund specializing in this); or
• an IPO by which the company becomes publicly traded.

! Issuers of venture capital include formative-stage companies that are either new or young and expansion-stage companies that need funds to expand their revenues or preparefor an IPO.

Question 25

Risks of distressed securities strategy

Answer 25

Investors need to assess the risks that a particular distressed securities strategy may entail. The risks may include one or more of the following:

• Event risk. Any number of unexpected company-specific or situation-specific risks may affect the prospects for a distressed securities investment. Because the event risk in this context is company specific, it has a low correlation with the general stock market.
• Market liquidity risk. Market liquidity in distressed securities is significantly less than for other securities, although the liquidity has improved in recent years. Also, market liquidity, dictated by supply and demand for such securities, can be highly cyclical in nature. This is a major risk in distressed securities investing.
• Market risk. The economy, interest rates, and the state of equity markets are not as important as the liquidity risks.
• J factor risk referred to the judge’s track record in adjudicating bankruptcies and restructuring as “J factor risk.” The judge’s involvement in the proceedings and the judgments will decide the investment outcome of investing in bankruptcy. The judge factor is also an important variable in determining which securities, debt or equity, of a Chapter 11-protected company to invest in.

It is difficult to estimate the true market values of the distressed securities, and stale pricing is inevitable. Stale valuation makes the distressed securities appear less risky. The risk of this strategy is probably understated, and its Sharpe ratio overstated.

As a result of the inability of some institutional investors to allocate funds to distressed securities, few sell-side analysts cover this area of the market. Given this limited following of distressed securities, undercovered and undervalued market opportunities exist that knowledgeable investors can exploit to earn high returns.

Although long-term returns for distressed securities show negative monthly returns for 20 percent of all months studied, the maximum 1-month and 12-month drawdowns are smaller for distressed securities than for US and world equities and bonds.

Question 26

Comparison of distressed securities, real estate and PE (in terms of return, risk-adjusted return, diversificating potential)

Answer 26

• Distressed securities outperform both stocks and bonds absolutely with higher Sharpe ratios than either. It is also poorly correlated with the stock market, so it would diversify a stock portfolio.
• Private equity has historically delivered better returns than stocks, but it is highly correlated with the stock market and the Sharpe ratios are quite high.
• Direct investments in real estate generally provide returns lower than those of stocks, though they do provide substantial diversification benefits.

Question 27

Benchmarks in Real Estate

Answer 27

• The principal benchmark used to measure the performance of direct real estate investment in the United States is the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index.
• Returns calculated solely on percentage changes in the index suffer from a number of deficiencies, including the tendency to underestimate volatility in underlying values. However, methods have been developed to “unsmooth” or correct for this bias.
• The principal benchmark used to represent indirect investment in real estate is the index compiled by the NAREIT.

Question 28

Roles of PE in the Portfolio

Answer 28

• The moderately high average correlation of private equity returns with publicly traded share returns that has been documented has an economic explanation that is at least plausible: All types of businesses have some exposure to economic and industry conditions, so correlations of public and private equity returns may be expected to be positive.
• Private equity bears more idiosyncratic or company-specific risk than the average seasoned public company, however, so any correlation should not be extremely high.
• Many investors look to private equity investment for long-term return enhancement.

Among the issues that must be addressed in formulating a strategy for private equity investment are the following:

1. Ability to achieve sufficient diversification.
2. Liquidity of the position.
3. Provision for capital commitment. An investor in a private equity fund makes a commitment of capital. The cash is advanced over a period of time known as the commitment period, which is typically five years. Therefore, the investor needs to make provisions to have cash available for future capital calls.
4. Appropriate diversification strategy. An investor contemplating an exposure to private equity should be clear on the stand-alone risk factors of an investment and also the effect on the overall risk of the portfolio. Each private equity fund will have a different investment focus, which when combined with other funds in the portfolio, modifies the overall risk.

Question 29

Contrast “fallen angels” to high-yield debt

Answer 29

The term “fallen angels” refers to debt securities that were originally deemed investment grade when issued by financially healthy companies but have subsequently been downgraded to below investment grade.

In contrast, companies with high risk profiles and existing senior debt issues can seek additional (subordinated) financing via originally issued high-yield securities.

Question 30

Prepackaged Bankruptcy Filing

Answer 30

In a prepackaged bankruptcy filing, the debtor agrees in advance with its creditors on a plan or reorganization before it formally files for protection under Chapter 11. Creditors usually agree to make concessions in return for equity in the reorganized company.

Question 31

Private placement memorandum

Answer 31

Private placement memorandum - a document used to raise venture capital financing when funds are raised through an agent

Question 32

Types of Distressed Securities Investments

Answer 32

Investors may access distressed securities investing through two chief structures:

1. Hedge fund structure. This is the dominant type. For the hedge fund manager, it offers the advantage of being able to take in new capital on a continuing basis. The AUM fee and incentive structure, particularly when there is no hurdle rate associated with the incentive fee, may be more lucrative than with other structures. Investors generally enjoy more liquidity (that is, can withdraw capital more easily) than with other structures.
2. Private equity fund structure. Private equity funds have a fixed term (i.e., a mandated dissolution date) and are closed end (they close after the offering period has closed). This structure has advantages where the assets are highly illiquid or difficult to value. An NAV fee structure may be problematic when it is difficult to value assets. When assets are illiquid, hedge fund–style redemption rights may be inappropriate to offer.

Distressed securities managers may themselves invest or trade in many types of assets, including the following:

• the publicly traded debt and equity securities of the distressed company;
• newly issued equity of a company emerging from reorganization that appears to be undervalued (orphan equity);
• bank debt and trade claims, because banks and suppliers owed money by the distressed company may want to realize the cash value of their claims. When the company is in reorganization, these instruments would be bankruptcy claims;
• “lender of last resort” notes; and
• a variety of derivative instruments for hedging purposes—in particular, for hedging the market risk of a position.

Question 33

Benchmarks and Historical Performance of Managed Futures

Answer 33

The benchmarks for managed futures are similar to those for hedge funds, in that indices represent performance of a group of managers who use a similar trading strategy or style.
! The primary benefit to managed futures is the significant diversification potential (improved Sharpe ratios). For example, some research has even shown that managed futures have exhibited positive correlation to equities and bonds during up markets and negative correlations during falling markets, in particular, private funds seemed to add value whereas publicly traded funds have performed poorly both stand-alone and in portfolios.

Question 34

Rohit Kumar is estimating the roll yield for an oil futures contract in backwardation based on the movement of the convenience yield. If the convenience yield increases, Kumar would MOST LIKELY estimate the roll yield to:

Decline.
Increase.
Not change

Answer 34

Increase

All else equal, a higher convenience yield (non-monetary benefit from owning the spot commodity) should lead to higher roll returns.

The rise in the convenience yield should increase the roll yield.

Question 35

Why can FOFs serve as better indicators of aggregate hedge fund performance then hedge fund indices?

Answer 35

• A FOF may serve as a better indicator of aggregate performance of hedge funds because they suffer from less survivorship bias. If a FOF includes fund that dissolves, the FOF includes the effect of failure in the return of the FOF; however, an index may simply drop the failed fund.
• A FOF can suffer from style drift. This can produce problems in that the investor may not know what he/she is getting. Over time, managers may tilt their respective portfolios in different directions. It is not uncommon that two FOFs claim to be the same style to have returns with a very low correlation.

Question 36

Comparison of Major Manager-Based Hedge Fund Indices

Answer 36

• The general distinguishing feature of various hedge fund series is whether they report monthly or daily series, are investable or noninvestable, and list the actual funds used in benchmark construction.
• Another important feature of the daily indices is that they are generally constructed from managed accounts of an asset manager rather than from the funds themselves.

There are many differences in the construction of the major manager-based hedge fund indices. Principal differences are as follows:

1. Selection criteria. Decision rules determine which hedge funds are included in the index. Examples of selection criteria include length of track record, AUM, and restrictions on new investment. For example, MSCI, Dow Jones, and Standard & Poor’s have specific rule-based processes for manager selection.
2. Style classification. Indices have various approaches to how each hedge fund is assigned to a style-specific index and whether or not a fund that fails to satisfy the style classification methodology is excluded from the index.
3. Weighting scheme. Indices have different schemes to determine how much weight a particular fund’s return is given in the index. Common weighting schemes are equally weighting and dollar weighting on the basis of AUM. Many indices report both equal-weighted and asset-weighted versions.
4. Rebalancing scheme. Rebalancing rules determine when assets are reallocated among the funds in an equally weighted index. For example, some funds are rebalanced monthly; others use annual rebalancing.
5. Investability. An index may be directly or only indirectly investable. The majority of monthly manager-based hedge fund indices are not investable, whereas most of the daily hedge fund indices are investable but often in association with other financial firms.

Question 37

Performance Evaluation Concerns for Hedge Funds

Answer 37

In reviewing the performance of a hedge fund, some factors an investor needs to consider are:

• the returns achieved;
• volatility, not only standard deviation but also downside volatility;
• what performance appraisal measures to use;
• correlations (to gain information on diversification benefits in a portfolio context);
• skewness and kurtosis because these affect risk and may qualify the conclusions drawn from a performance appraisal measure; and
• consistency, including the period specificity of performance.

Question 38

Equity market neutral vs. Hedged equity strategies

Answer 38

• Equity market neutral* is usually the attempt to exploit price discrepancies through long and short positions. This strategy also has the goal of the systematic risks canceling because of the long and short positions.
• Hedged equity strategies* take long and short positions in under and overvalued securities, respectively, like equity market neutral strategies. The difference is that hedged equity strategies do not focus on balancing the positions to eliminate systematic risks.

Question 39

Liquidity of hedge funds compared to distressed secuities

Answer 39

Hedge fund structured investments are ususally more liquid than investments in distressed equity using the private equity structure.

Question 40

PE Fund Selection: factors to consider

Answer 40

Fund selection is largely an exercise in evaluating the capabilities of the general manager’s management team. Factors that should be considered include the following:

• historical returns generated on prior funds;
• consistency of returns. Has the team had one successful fund or many?
• roles and capabilities of specific individuals at the fund. The investor will want to evaluate whether the fund manager has the needed human resources to effectively select and guide private equity investment;
• stability of the team. Did the current senior personnel generate the track record of the fund manager, or has there been significant personnel turnover?

Question 41

Other Issues of Managed Futures investing

Answer 41

Past CTA performance may be valuable in forecasting CTA and multi-advisor CTA portfolios’ return and risk parameters, especially at the portfolio level.

Question 42

Roles of Distressed Securities in the Portfolio

Answer 42

Long-Only Value Investing

The simplest approach involves investing in perceived undervalued distressed securities in the expectation that they will rise in value as other investors see the distressed company’s prospects improve. When the distressed securities are public debt, this approach is high-yield investing. When the securities are orphan equities, this approach is orphan equities investing.

Distressed Debt Arbitrage

Distressed debt arbitrage (or distressed arbitrage) involves purchasing the traded bonds of bankrupt companies and selling the common equity short. The hedge fund manager attempts to buy the debt at steep discounts. If the company’s prospects worsen, the value of the company’s debt and equity should decline, but the hedge fund manager hopes that the equity, in which the fund has a short position, will decline to a greater degree. Indeed, as a residual claim, the value of equity may be wiped out. If the company’s prospects improve, the portfolio manager hopes that debt will appreciate at a higher rate than the equity because the initial benefits to a credit improvement accrue to bonds as the senior claim.

Private Equity

The investor usually first becomes a major creditor of the target company to obtain influence on the board of directors or, if the company is already in reorganization or liquidation, on the creditor committee. The investor buys the debt at deep discounts. The investor then influences and assists in the recovery or reorganization process. The objective of this focused active involvement is to increase the value of the troubled company by deploying the company’s assets more efficiently than in the past. If the investor obtains new shares in the company as part of the reorganization, the investor hopes to sell them subsequently at a profit.

Prepackaged bankruptcy - this type of operation is typically conducted by private equity firms. The firm (or team of firms, because the capital commitment may be major) takes a dominant position in the distressed debt of a public company. Working with the company and other creditors, the firm seeks to have a prepackaged bankruptcy in which the firm becomes the majority owner of a private company on favorable terms (the previous public equityholders losing their complete stake in the company).143 After restoring the company to better health, the firm has a company that can be sold to private or public investors.

Question 43

The Role of Real Estate as a Diversifier

Answer 43

• In addition to its potential to add value through active management, real estate has historically been viewed as an important diversifier.
• Real estate as an asset class typically responds differently from the way either stocks or bonds do. The reason is that, in the past, directly owned real estate was not highly correlated with the performance of other assets.
• Direct real estate investment may provide some diversification benefits to stocks and bonds but benefits may disappear when hedge funds and commodities are added to the portfolio.

Question 44

Vintage year, vintage year effects

Answer 44

In evaluating past records of returns of private equity funds, investors often make comparisons with funds closed in the same year (the funds’ vintage year). This helps assure the funds are compared with other funds at a similar stage in their life cycle. The effects of vintage year on returns are known as “vintage year effects,” and include, in addition to the effects of life-cycle stage, the influence that economic conditions and market opportunities associated with a given vintage year may have on various funds’ probabilities of success.

Vintage year in the private equity and venture capital industries is a year in which the firm began making investments.

Question 45

On September 1, 201X, Rey Rodriguez purchased a natural gas futures contract for $4.15 that expires in December 201X. As of October 1, 201X, the price on the futures contract was $4.37. Between September 1 and October 1, the spot price increased by $0.15. The risk-free rate on the T-Bill is 3.0%. From September 1 to October 1, the greatest return on the futures contract is MOST LIKELY from the:

• Collateral Return.
• Spot Return.
• Roll Yield.

Answer 45

Spot Return

The spot return equals the change in the spot price of $0.15.

The collateral return equals the money earned by investing the 100 percent margin used to purchase the futures contract in T-bills. The collateral return on $4.15 for one-month at a 3% annual rate is:

$4.15 x 0.03 x (1/12) = $0.01

The roll yield equals the change in the futures prices between September and October minus the change in the spot price. The roll yield is:

($4.37 - $4.15) - $0.15 = $0.07

Question 46

Alternative investments by the primary role they usually play in portfolios

Answer 46

In addition to the traditional-or-modern distinction, we can place alternative investments in three groups by the primary role they usually play in portfolios:

• Investments that primarily provide exposure to risk factors not easily accessible through traditional stock and bond investments. Real estate and (long-only) commodities might be included in this group.
• Investments that provide exposure to specialized investment strategies run by an outside manager. Hedge funds and managed futures might be placed in this category. Any value added by such investment is typically heavily dependent on the skills of the manager.
• Investments that combine features of the prior two groups. Private equity funds and distressed securities might be included in this group.

Question 47

Roles of Commodities in the Portfolio

Answer 47

The principal roles that have been suggested for commodities in the portfolio are as:

• a potent portfolio risk diversifier, and
• an inflation hedge, providing an expected offset to the losses to such assets as conventional debt instruments, which typically lose value during periods of unexpected inflation.
• the returns of commodities have generally been lower over the longer period of 1990-2004 than stocks and bonds both absolutely and on a risk-adjusted basis. The energy subgroup commodities has had the highest returns, and without it, the broad GSCI index returns would have been much lower.

Question 48

The compensation to the fund manager of a private equity fund

Answer 48

• The compensation to the fund manager of a private equity fund consists of a management fee plus an incentive fee. The management fee is usually a percentage of limited partner commitments to the fund. (If the investor has made a capital commitment of US$50 million but actually invested only US$10 million, the investor generally pays a management fee on the US$50 million committed.) Management fees are often in the 1.5–2.5 percent range and often scale down in the later years of a partnership to reflect a lower work load.
• The fund manager’s incentive fee, the carried interest, is the share of the private equity fund’s profits that the fund manager is due once the fund has returned the outside investors’ capital (which may be specified as the capital committed or the capital invested). Carried interest is usually expressed as a percentage of the total profits of the fund. A common value is 20 percent.
• In some funds, the carried interest is computed on only those profits that represent a return in excess of a hurdle rate (the hurdle rate is also known as the preferred return). A hurdle rate of 6 percent means that only the private equity fund’s profits in excess of an annualized return of 6 percent are subject to the 20 percent carried interest. Because early investments by the fund may achieve high rates of return but later investments do poorly, private equity funds sometimes have a claw-back provision that specifies that money from the fund manager be returned to investors if at the end of a fund’s life investors have not received back their capital contributions and contractual share of profits.
• In distributing cash flows to investors and the fund manager, a private equity fund first distributes to investors their invested capital and preferred return (if any is specified). Sometimes, the fund manager is allowed to take a small percentage of early distributions. Typically, following the period in which all or most distributions go to investors, there is a catch-up period in which the fund manager receives all or the major share of profits.

Question 49

Correlation with inflation of storable and non-storable commodities

Answer 49

Commodity classes such as livestock and agriculture exhibit negative correlation with unexpected inflation as measured by monthly changes in the inflation rate. Thus they are poor inflation hedges.

Storable commodities directly linked to economic activity exhibit positive correlation with changes in inflation and have superior inflation-hedging properties.

Question 50

With respect to the seed and strat-up point in the early stage of venture capital, which of the two represents a point where the company has already started generating revenue?

Answer 50

In neither the seed nor start-up point.

The stages through which private companies pass are the early-stage, later-stage and exit-stage. The early stage consists of:

• seed: the small amount of money provided by the entrepreneur to get the idea off the ground
• start-up: susally pre-revenue stage that brings the entrepreneur`s idea to commercialization
• first stage: additional funds if the idea is sound but start-up funds have run out.

The later-stage occurs after revenue has started.

Question 51

Do commodities exhibit positive event risk?

Answer 51

Changes in commodity futures prices are highly correlated with changes in spot prices. In periods of financial, economic, or political distress, and sometimes after natural disasters, short-term commodity prices tend to rise because most such events create shocks with respect to physical commodities that reduce current supply and cause prices to rise. This is called “positive event risk.”

Question 52

Primary similarity and a primary difference between managed futures and many other hedge fund strategies

Answer 52

The primary similarity between managed futures and absolute-return hedge fund strategies is that they seek positive returns regardless of market direction.

Managed futures strategies invest exclusively in the forward and derivatives markets on a leveraged basis by trading futures and options contracts in the financial, commodity, and currency markets. In contrast, other hedge fund strategies invest in underlying markets; some, depending on their strategies, also use derivatives.

Question 53

Investment Characteristics of Investing in Real Estate

Answer 53

• The physical real estate market is characterized by relative lack of liquidity, large lot sizes, relatively high transaction costs, heterogeneity, immobility (with the asset fixed at a location), and relatively low information transparency (so the seller often knows more than the buyer).
• The lack of reliable, high-frequency transaction data for properties necessitates the use of appraisal-based valuations.
• Various market and economic factors affect real estate. For instance, interest rates directly or indirectly affect a multitude of factors associated with the demand and supply for real estate, such as business financing costs, employment levels, savings habits, and the demand and supply for mortgage financing. Worldwide, the returns to real estate are positively correlated with changes in gross national product. Population growth is, in the long term, a positive factor for real estate returns.
• Real estate values are affected by idiosyncratic variables, such as location. Complete diversification in real estate can be achieved only by investing internationally.

Question 54

Contango vs. Normal backwardation

Answer 54

• Contango is when the futures price is above the expected future spot price. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time as new information brings them into line with the expected future spot price.
• Normal backwardation is when the futures price is below the expected future spot price. This is desirable for speculators who are “net long” in their positions: they want the futures price to increase. So, normal backwardation is when the futures prices are increasing.

Question 55

The compensation structure of hedge funds

Answer 55

• The compensation structure of hedge funds comprises a percentage of net asset value (NAV) as a management fee plus an incentive fee. The management fee is also known as an “asset under management” or AUM fee. The management fee generally ranges from 1 percent to 2 percent. The incentive fee is a percentage of profits as specified by the terms of the investment.
• The great majority of funds have a high-water mark provision that applies to the payment of the incentive fee. Intuitively, a high-water mark (HWM) is a specified net asset value level that a fund must exceed before performance fees are paid to the hedge fund manager. Once the first incentive fee has been paid, the highest month-end NAV establishes a high-water mark. If the NAV then falls below the HWM, no incentive fee is paid until the fund’s NAV exceeds the HWM; then the incentive fee for a “1 plus 20” structure (a 1 percent management fee plus a 20 percent incentive fee) is 20 percent of the positive difference between the ending NAV and the HWM NAV. The new, higher NAV establishes a new HWM. A minority of funds also specify that no incentive fee is earned until a specified minimum rate of return (hurdle rate) is earned.
• Hedge funds also prescribe a minimum initial holding or lock-up period for investments during which no part of the investment can be withdrawn. Lock-up periods of one to three years are common. Thereafter, the fund will redeem the investments of investors only within specified exit windows—for example, quarterly after the lock-up period has ended. The rationale for these provisions is that the hedge fund manager needs to be insulated to avoid unwinding positions unfavorably. FOFs usually do not impose lock-up periods and may permit more frequent investor exits. However to offer that additional liquidity, the FOF manager must hold a cash buffer that may reduce expected returns.

Question 56

Five broad groups classification of Hedged Funds

Answer 56

One provider of hedge fund benchmarks classifies strategies into the following five broad groups:

1. Relative value, in which the manager seeks to exploit valuation discrepancies through long and short positions. This label may be used as a supercategory for, for example, equity market neutral, convertible arbitrage, and hedged equity.
2. Event driven, in which the manager focuses on opportunities created by corporate transactions (e.g., mergers). Merger arbitrage and distressed securities would be included in this group.
3. Equity hedge, in which the manager invests in long and short equity positions with varying degrees of equity market exposure and leverage.
4. Global asset allocators, which are opportunistically long and short a variety of financial and/or nonfinancial assets.
5. Short selling, in which the manager shorts equities in the expectation of a market decline.

The five most widely used hedge fund strategies, accounting for 85–90 percent of assets under management in the hedge fund industry as of the early 2000s, are three equity-based strategies (equity market neutral, hedged equity, and merger arbitrage), one fixed-income strategy (convertible arbitrage), and global macro, which uses all types of assets, including currencies and commodities.

Question 57

Roles of Managed Futures in the Portfolio

Answer 57

• Managed futures appear to be useful in diversifying risk even in a diversified portfolio of stocks, bonds, and hedge funds.
• It appears that an investor can fairly closely track the performance of a CTA-based managed futures index by using a small random selection of CTAs.
• For managed futures fund, a trend-following strategy will offer lower diversification than a contrarian strategy. This should be obvious since the trends would be those of the cash markets for which the investor is trying to obtain diversification

Question 58

In distressed securities investing, the fact that there can be cyclical supply and demand for these investments is associated with?

• market liquidity risk
• J-factor risk
• arbitrage risk

Answer 58

Market liquidity risk refers to the low liquiditiy and the fact that there canbe cyclical supply and demand for these investments.

Question 59

Special Risk Characteristics of Commodities

Answer 59

In periods of financial and economic distress, commodity prices tend to rise, potentially providing valuable diversification services in such times.

Commodities are generally business-cycle sensitive. The reason commodities behave differently under different economic conditions has to do with the sources of their returns. The determinants of commodity returns include the following:

1. Business cycle–related supply and demand. Commodity prices are expected to be sensitive to the business cycle but have little or even negative correlation with stocks and bonds. Three reasons commodity returns have been weakly correlated with stock and bond returns. First, commodities correlate positively with inflation whereas stocks and bonds are negatively correlated with inflation. Second, commodity prices and stock/bond prices react differently in different phases of the business cycle. Commodity future prices are more affected by short-term expectations, whereas stock and bond prices are affected by long-term expectations. Finally, commodity prices tend to decline during times of a weak economy.
2. Convenience yield. The theory of storage splits the difference between the futures price and the spot price into three components: the forgone interest from purchasing and storing the commodity, storage costs, and the commodity’s convenience yield. Convenience yield reflects an embedded consumption-timing option in holding a storable commodity.
   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 time to expiration of the futures contract—the so-called Samuelson effect. This is caused by the expectation that, although at shorter horizons mismatched supply and demand forces for the underlying commodity increase the volatility of cash prices, these forces will fall into equilibrium at longer horizons.
3. Real options under uncertainty. Oil futures markets are often backwardated; in these markets, futures prices are often below the current spot price. This may be caused by the existence of real options under uncertainty. A real option is an option involving decisions related to tangible assets or processes. In other words, producers are holding valuable real options—options to produce or not to produce—and will not exercise them unless the spot prices start to climb up. Production occurs only if discounted futures prices are below spot prices, and backwardation results if the risk of future prices is sufficiently high. A major consequence of a downward-sloping term structure of futures prices is the opportunity to capture a positive roll return as investment in expiring contracts is moved to cheaper new outstanding contracts.

!!! Since producers have the real option of producing more oil now or delaying production to any future month, they will choose to exercise this right whenever it’s profitable to them in their estimation, which of course would be cued by the futures curve of prices, if the futures price is lower then more oil will be produced now to take advantage of higher spot, while if the futures price is higher more future delivery contracts will be written to take advantage of higher prices in the future. This latter case may be due to a glut of oil inventories driving down prices in spot

Question 60

Investment Characteristics of Private Equity

Answer 60

The general investment characteristics of private equity investments include the following:

• Illiquidity. Private equity investments are generally highly illiquid. Convertible preferred stock investments do not trade in a secondary market. Private equity fund investors have more restricted opportunities to withdraw investments from the fund than do hedge fund investors. This is natural, because the underlying investments are not liquid.
• Long-term commitments required. Private equity investment generally requires long-term commitments. For direct VC investments, the time horizon also can be quite uncertain.
• Higher risk than seasoned public equity investment. The returns to private equity investments, on average, show greater dispersion than seasoned public equity investments, although they may be roughly comparable to those of publicly traded microcap shares. The risk of complete loss of investment is also higher. The failure rate of new and young businesses is high. *A seasoned equity offering or secondary equity offering (SEO) is a new equity issue by an already publicly traded company.
• High expected IRR required. Private equity investors target high rates of returns as compensation for the risk and illiquidity of such investments.

For venture capital investments, the following also holds:

• Limited information

Question 61

Private Equity/Venture Capital

Answer 61

• Private equity refers to any security by which equity capital is raised via a private placement rather than through a public offering. As private placements, private equity securities are not registered with a regulatory body. To qualify as private placements, securities are generally offered for sale to either institutions or high-net-worth individuals (accredited investors).
• Private equity funds — the pooled investment vehicles through which many investors make (indirect) investments in generally highly illiquid assets. These investment activities range from financing private businesses, to leveraged buyouts of public companies, to distressed debt investing, to the private financing of public infrastructure projects.

Question 62

For hedge funds, the basic incentive fee for managers may not be adequate bacause?

Answer 62

A hedge dund manger may have several goals other than earning a high return, e.g. lowering downside risk.

The rationale for incentive fees is obvious: encourage the manager to earn higher profits. There is some controversy concerning fees because a manger may have or should have other goals than simply earning a gross return. For example, the manager may/should be providing limited downside risk and diversification. The basic incentive fee does not reward this service.

Question 63

Absolute Priority Rule

Answer 63

• In the United States, a reorganization plan must follow the rule of priority with respect to the order of claims by its security holders. In general, claims from senior secured debtholders (typically, bank loans) will be satisfied first. The debtor’s bondholders come next. The distribution may be split between senior and subordinated bondholders. Last on the list are the debtor’s shareholders.
• There is an exception to the absolute priority rule, which is referred to as “the new value exception.” In the new value exception, the debtor’s shareholders seek to retain all or a portion of their equity interest by making what amounts to a capital contribution. In exchange for their contribution, they retain their interest even in the face of a dissenting vote by a senior class of creditors. The US Supreme Court has held, however, that the new value exception does not permit contribution of such value without competitive bidding or some other mechanism to establish the adequacy of the contribution.

Question 64

Do hedgers pay a risk premium to liquidity providers, such as Commodity Trading Advisors (CTA), for the insurance that the hedgers obtain?

Are CTAs more likely to be able to conduct profitable arbitrage trades between stock, bond, futures, options, and cash markets because of differential carrying costs between investors?

Answer 64

Hedgers may pay a risk premium to liquidity providers for the insurance they obtain so managed futures may be able to earn positive excess returns.

Differential carrying costs among investors may permit managed fund traders to take advantage of short-term pricing differences between theoretically identical stock, bond, futures, options, and cash market positions.

Question 65

Volatility and Downside Volatility of Hedge Funds

Answer 65

The annualized standard deviation is usually computed as the standard deviation of the monthly return times the square root of 12, making the assumption of serially uncorrelated returns. The use of the standard deviation of monthly returns as a measure of risk also makes the implicit assumption that the return distribution follows the normal distribution, at least to a close approximation. As already mentioned, however, hedge funds appear to have more instances of extremely high and extremely low returns than would be expected with a normal distribution (i.e., positive excess kurtosis) and some funds also display meaningful skewness. When those conditions hold, standard deviation incorrectly represents the actual risk of a hedge fund’s strategies.

Downside deviation, or semideviation, is an alternative risk measure that mitigates one critique of standard deviation, namely, that it penalizes high positive returns. Downside deviation computes deviation from a specified threshold (i.e., below a specified return, r*); only the negative deviations are included in the calculation.

Using downside deviation instead of standard deviation recognizes a distinction between good and bad volatility:

Downside deviation=SQRT(∑_n^{<span>i=1</span>}[min(r_t−r*,0)]²/(n−1))

if monthly returns are used do not forget multipliying by SQRT(12)

Another popular risk measure is drawdown. As discussed in the reading on risk management, drawdown in the field of hedge fund management is the difference between a portfolio’s point of maximum net asset value (its high-water mark) and any subsequent low point (until new “high water” is reached). Maximum drawdown is the largest difference between a high-water point and a subsequent low. A portfolio may also be said to be in a position of drawdown from a decline from a high-water mark until a new high-water mark is reached. How long this period lasts is relevant to evaluating hedge fund performance—in particular, its record of recovering from losses.

Question 66

Vulture fund

Answer 66

A vulture fund is a private equity fund that uses an “active” approach where the fund of investor aquires positions in the company, and the investment gives some measure of control. The investor can then influence and assist the company and then aquire more ownership in the process of any reorganization. By providing services and obtaining a strategic position, the investors create their own opportunity.

Question 67

General advantages and disadvantages of direct equity real estate investing

Answer 67

Advantages

1. To the extent that the law allows mortgage interest, property taxes, and other expenses to be tax deductible, taxable owners of real estate may benefit from tax subsidies.
2. Mortgage loans permit most real estate borrowers to use more financial leverage than is available in most securities investing.
3. 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. In contrast, an investor who owns a small position in the equity of a publicly traded company has virtually no voice in the management of the company.
4. 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.
5. Real estate returns, on average, have relatively low volatility in comparison with returns to public equities—even after correcting for the downward bias that results from the smoothing process associated with real estate appraisals. We discuss this bias later.

Disadvantages

1. Most parcels of real estate are not easy to divide into smaller pieces. As a result, when such properties are a relatively large part of an investor’s total portfolio, real estate investing may involve large idiosyncratic risks for investors. Owners of single-family residences and large institutional investors that buy shopping centers may both experience this problem.
2. The cost of acquiring information is high because each piece of real estate is unique.
3. Real estate brokers charge high commissions relative to securities transaction fees.
4. Real estate involves substantial operating and maintenance costs (e.g., for administration, leasing, repairs, and replacements) and hands-on management expertise, which are expenses or requirements not incurred by securities investors.
5. Real estate investors are exposed to the risk of neighborhood deterioration, and the conditions that may lead to that are beyond the investor’s control.
6. Any income tax deductions that a taxable investor in real estate may benefit from are subject to political risk—they may be discontinued.

Question 68

Explain how rolling returns can provide additional information about the hedge fund’s performance

Answer 68

Rolling returns can show how consistent the returns are over the investment period and whether there is any cyclicality in the returns.

Question 69

PIPE

Answer 69

Private Investment in Public Entity (PIPE) - through a PIPE, an investor makes a relatively large investment in a company, usually at a price less than the current market value.

Question 70

Managed futures

Answer 70

Managed futures are private pooled investment vehicles that can invest in cash, spot, and derivative markets for the benefit of their investors and have the ability to use leverage in a wide variety of trading strategies. Like hedge funds, managed futures programs are actively managed. Similar to hedge funds, with which they are often grouped, managed futures programs are often structured as limited partnerships open only to accredited investors (institutions and high-net-worth individuals). Compensation arrangements for managed futures programs are also similar to those of hedge funds. The primary distinguishing differences between hedge funds and managed futures is that, for the most part, managed futures trade exclusively in derivative markets (future, forward, or option markets) whereas hedge funds tend to be more active in spot markets while using futures markets for hedging. Because hedge funds often trade in individual securities whereas managed futures primarily trade market-based futures and options contracts on broader or more generic baskets of assets, one can view hedge funds as concentrating on inefficiencies in micro (security) stock and bond markets whereas managed futures look for return opportunities in macro (index) stock and bond markets. In addition, in some jurisdictions, managed futures programs have been historically more highly regulated than hedge funds.

Question 71

List and discuss the sources of return available to managed futures programs through the use of derivative trading strategies

Answer 71

Similarly to market-neutral funds, managed futures programs can replicate many strategies available to cash market investors at lower transaction costs and can also trade on strategies by using derivatives that are unavailable to cash market investors. Research has shown that when returns are segmented according to whether the stock/bond markets rose or fell, managed futures have a negative correlation with cash market portfolios when cash market portfolios post significant negative returns and are positively correlated when cash portfolios reported significant positive returns. Therefore, managed futures may offer unique asset allocation characteristics in different market environments.

Also, hedging demands of cash market participants may create investment situations where hedgers are required to offer derivative investors a risk premium, or positive return, for holding open long or short offsetting positions. Option traders may be able to create positions that offer this “risk premium” for holding various option contracts when cash market participants increase purchases of options to protect themselves in markets with trending prices or volatility. This return (i.e., the convenience yield) can be earned simply by buying and holding a derivatives portfolio.

Question 72

The Managed Futures Market

Answer 72

Managed futures programs are an industry comprising specialist professional money managers. In the United States, such programs are run by general partners known as commodity pool operators (CPOs), who are, or have hired, professional commodity trading advisors to manage money in the pool.

Question 73

Credit and market risks of equity market-neutral, convertible arbitrage and global maco hedge strategies

Answer 73

Equity market-neutral

• Market risk*: little
• Credit risk*: low credit risk because their long–short positions result in net low leverage

Convertible arbitrage

• Market risk*: low market exposure due to hedging
• Credit risk*: this strategy also increases credit risk considerably because hedging via derivative instruments creates high leverage exposure

Global maco

• Market risk*: high market exposure
• Credit risk*: given their extensive use of leverage via futures and options, they are also exposed to significant credit (leverage) risk.

Question 74

Historical Performance of Hedge Funds

Answer 74

Including hedge funds can also frequently lead to lower skewness and higher kurtosis, which are exactly opposite to the attributes (positive skewness and moderate kurtosis) that investors are presumed to want.

The following are techniques for neutralizing negative skewness in a portfolio resulting from hedge fund positions that a portfolio manager may consider:

• Adopt a mean–variance, skewness and kurtosis–aware approach to hedge fund selection. An example is given in Kat (2005), who discussed combining global macro and equity market-neutral hedge strategies with traditional assets. Global macro funds have tended to have positive skewness with only moderate correlation with equities but relatively high kurtosis and volatility; equity market-neutral strategies tend to act as volatility and kurtosis reducers in the portfolio. In other words, smart hedge fund selection may be able to reduce the problem of negative skewness.
• Invest in managed futures. Managed futures programs are generally trend following in nature, which tends to produce skewness characteristics that are opposite to those of many hedge funds.

Question 75

Commodities as an Inflation Hedge

Answer 75

Direct investment in energy—and, to a lesser degree, industrial and precious metals—may provide a significant inflation hedge.

Question 76

Investment Characteristics of Distressed Securities

Answer 76

• Many investors are barred either by regulations or by their investment policy statements from any substantial holdings in below-investment-grade debt. These investors must sell debt that has crossed the threshold from investment grade to high yield (so-called fallen angels).
• Failed leveraged buyouts have also been a source of distressed securities opportunities.

Question 77

Relationship between Chapter 7 and Chapter 11

Answer 77

A debtor against whom an involuntary Chapter 7 is filed has a right to convert the case to a Chapter 11 proceeding. Similarly, a Chapter 7 debtor that filed a voluntary petition can convert the case to a Chapter 11, unless the case started as a Chapter 11. In addition, the court can convert a Chapter 11 case to Chapter 7 or dismiss the case for cause (e.g., the inability of the debtor to carry out a plan) at any point in the case. The latter uncertainty adds much risk to bankruptcy investors.

Question 78

Issuers of venture capital include (Demand for Venture Capital)

Answer 78

Issuers of venture capital include the following:

• Formative-stage companies. This group ranges from newly formed companies, to young companies beginning product development (“start-ups”), to companies that are just beginning to sell a product.
• Expansion-stage companies. This group ranges from young companies that need financing for expanding sales, to established companies with significant revenues (middle-market companies), to companies that are preparing for an IPO of stock.

Question 79

CPO and CTA - definitions

Answer 79

Managed futures programs are typically run by Commodity Pool Operators (CPOs). CPOs cen themselves be commodity trading advisors (CTAs) or will hire CTAs to acuallty manage all part of the pool. In the United States, both must be registred with the U.S. Commodity Futures Trading Commission and the National Futures Association. Some CTAs may choose to work independently outside of a public or private CPO structure.

Question 80

Distressed securities

Answer 80

• Distressed securities are the securities of companies that are in financial distress or near bankruptcy. In the United States, investing in distressed securities involves purchasing the claims of companies that have already filed for Chapter 11 (protection for reorganization) or are in immediate danger of doing so. Under Chapter 11 protection, companies try to avoid Chapter 7 (protection for liquidation) through an out-of-court debt restructuring with their creditors.
• Investment strategies using distressed securities exploit the fact that many investors are unable to hold below-investment-grade securities because of regulatory or investment policy restrictions.

Question 81

Alternative investments

Answer 81

Alternative investments comprise groups of investments with risk and return characteristics that differ markedly from those of traditional stock and bond investments. Common features of alternative investments include:

• relative illiquidity, which tends to be associated with a return premium as compensation;
• diversifying potential relative to a portfolio of stocks and bonds;
• high due diligence costs for the following reasons: investment structures and strategies may be complex; evaluation may draw heavily on asset-class, business-specific, or other expertise; reporting often lacks transparency; and
• unusually difficult performance appraisal because of the complexity of establishing valid benchmarks.

In addition, many professional investors believe that alternative investment markets are informationally less efficient than the world’s major equity and bond markets and offer greater scope for adding value through skill and superior information.

Historically, real estate (ownership interests in land or structures attached to land), private equity (ownership interests in non-publicly-traded companies), and commodities (articles of commerce such as agricultural goods, metals, and petroleum) have been viewed as the primary alternatives to traditional stock and bond investments. However, in recent years, additional investments—hedge funds (relatively loosely regulated, pooled investment vehicles) and managed futures (pooled investment vehicles in futures and options on futures, frequently structured as limited partnerships)—have increasingly been considered “modern alternatives,” not only to traditional investments but also to traditional alternative investments.

Question 82

Sortino ratio, gain-to-loss ratio

Answer 82

The Sortino ratio replaces standard deviation in the Sharpe ratio with downside deviation. Instead of using the mean rate of return to calculate the downside deviation, the investor’s minimum acceptable return or the risk-free rate is typically used.

The Sortino ratio is

Sortino ratio=(Annualized rate of return − Annualized risk-free rate)/Downside deviation

!!! Annualized rate of return = geometric mean per year: = ([(1+r₁)(1+r₂)…(1+r₁₂)]^1/12-1)*12

The gain-to-loss ratio measures the ratio of positive returns to negative returns over a specified period of time. The higher the gain-to-loss ratio (in absolute value), the better:

Gain-to-lossratio=(Number months with positive returns / Number months with negative returns)×(Average up - month return / Average down-month return)

Two major appraisal measures based on drawdowns as indicators of risk, the Calmar ratio and the Sterling ratio, have been applied to hedge fund analysis.

Question 83

Core–Satellite Investing

Answer 83

A traditional core–satellite perspective places competitively priced assets, such as government bonds and/or large-capitalization stocks, in the core. Because alpha is hard to obtain with such assets, the core may be managed in a passive or risk-controlled active manner. (Informally, alpha is the return to skill.) In the satellite ring would go investments designed to play special roles, such as to add alpha or to diminish portfolio volatility via low correlation with the core.

Question 84

Alpha Determination and Absolute-Return Investing

Answer 84

Hedge funds have often been promoted as absolute-return vehicles. Absolute-return vehicles have been defined as investments that have no direct benchmark portfolios. Estimates of alpha, however, must be made relative to a benchmark portfolio.

The lack of a clear hedge fund benchmark, however, is not indicative of an inability to determine comparable returns for a hedge fund strategy. Hedge fund strategies within a particular style often trade similar assets with similar methodologies and are sensitive to similar market factors. Two principal means of establishing comparable portfolios are:

1. using a single-factor or multifactor methodology and
2. using optimization to create tracking portfolios with similar risk and return characteristics.

Question 85

Hurdle rate

Answer 85

Hurdle rate may refer to a minimum acceptable rate of return on a project

Question 86

Critique the following statement: “When the economy has been faltering and may be going into recession, it is typically a good time to invest in distressed securities.”

Answer 86

The statement is correct. When the economy is in a downturn, there are more bankruptcies, thereby increasing the supply of distressed securities at relatively low (or falling) prices.

Question 87

Commodity trading advisor (CTA) strategies

Answer 87

Commodity trading advisor (CTA) strategies can be described as systematic or discretionary.

CTAs that specialize in systematic trading strategies typically apply sets of rules to trade according to short, intermediate, and/or long-term trends. They may also trade counter to trends in a contrarian (against the trend) strategy.

A discretionary trading strategy is based on the discretion of the CTA, in the same way that any active manager seeks value.

Managed futures can also be classified according to the markets in which they trade. They apply systematic or discretionary trading strategies in financial markets, currency markets, or diversified markets. In financial markets, they trade in financial (i.e., interest rate) and currency futures, options, and forward contracts. Those that specialize in currency markets trade exclusively in currency derivatives. A fund that trades in diversified markets trades in all the financial derivatives markets described as well as commodity derivatives.

Question 88

How can the Sharpe ratio be gamed?

Answer 88

The Sharpe ratio can be gamed; that is, the reported Sharpe ratio can be increased without the investment really delivering higher risk-adjusted returns. Specifically, there are the following means to gaming the Sharpe ratio:

• Lengthening the measurement interval. This will result in a lower estimate of volatility; for example, the annualized standard deviation of daily returns is generally higher than the weekly, which is, in turn, higher than the monthly.
• Compounding the monthly returns but calculating the standard deviation from the (not compounded) 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. Strategies that involve taking on default risk, liquidity risk, or other forms of catastrophe risk have the same ability to report an upwardly biased Sharpe ratio. (Examples are the Sharpe ratios of market-neutral hedge funds before and after the 1998 liquidity crisis.) This is similar to trading negative skewness for a greater Sharpe ratio by improving the mean or standard deviation of the investment.119
• Smoothing of returns. Using certain derivative structures, infrequent marking to market of illiquid assets, and pricing models that understate monthly gains or losses can reduce reported volatility.
• Getting rid of extreme returns (best and worst monthly returns each year) that increase the standard deviation. Operationally, this entails a total-return swap: One pays the best and worst returns for one’s benchmark index each year, and the counterparty pays a fixed cash flow and hedges the risk in the open market. If swaps are not available, one can do it directly with options.

Question 89

Due diligence in alternative investments

Answer 89

The costs of due diligence in alternative investments may be a limiting factor for smaller portfolios.

Chief points of active manager selection process:

1. Market Opportunity What is the opportunity and why is it there? We start by studying capital markets and the types of managers operating within those markets. We identify market inefficiencies and try to understand their causes, such as regulatory structures or behavioral biases.
2. Investment Process Who does this best and what’s their edge? We identify groups of managers that seek to exploit these inefficiencies.
3. Organization Are all the pieces in place? Is the firm well organized and stable? Are research, trading, risk management, and operations properly staffed given the investment process and scale? Is compensation fair? Has there been turnover? What is the succession plan?
4. People Do we trust the people?
5. Terms and Structure Are the terms fair? Are interests aligned? Is the fund or account structured appropriately to the opportunity?
6. Service Providers Who supports them? We verify lawyers, auditors, prime brokers, lenders, etc. We investigate those with whom we are not familiar.
7. Documents Read the documents!
8. Write-Up Prior to making a manager selection decision, we produce a formal manager recommendation discussing the above steps.

Some questions in due diligence and alternative investment selection are unique, or more acute, for advisors of private wealth clients than for institutional investors. These include:

• Tax issues. This is a pervasive issue in investing for individuals. In contrast to equities and bonds, with alternative investments, the advisor will frequently be dealing with partnerships and other structures that have distinct tax issues.
• Determining suitability. This is often more complex for an advisor to an individual client or family than for an institutional investor. The advisor often addresses multistage time horizons and liquidity needs.
• Communication with client. The advisor then faces the difficult problem of communicating and discussing the possible role in the portfolio (and risk) of an often complex investment with a nonprofessional investor.
• Decision risk. Decision risk is increased by strategies that by their nature have:
  
  • frequent small positive returns but, when a large return occurs, it is more likely to be a large negative return than a large positive one, or
  • extreme returns (relative to the mean return) with some unusual degree of frequency.
• Concentrated equity position of the client in a closely held company.

Question 90

Skewness and Kurtosis

Answer 90

• A symmetrical distribution has a skewness of zero; all else being equal, a positive value of skewness is desirable.
• Kurtosis evaluates the relative incidence of returns clustered near the mean return versus returns extremely far away from the mean. If one investment has higher kurtosis than another, it tends to have more instances of extreme returns.

Question 91

Types of Commodity Investments

Answer 91

• Direct commodity investment entails cash market purchase of physical commodities—agricultural products, metals, and crude oil—or exposure to changes in spot market values via derivatives, such as futures. Cash market purchases involve actual possession and storage of the physical commodities and incur carrying costs and storage costs. Thus, investors have generally preferred to use derivatives or indirect commodity investment.
• Indirect commodity investment involves the acquisition of indirect claims on commodities, such as equity in companies specializing in commodity production. To the degree that companies hedge a major portion of their commodity risk, even commodity-linked companies may not be exposed to the risk of commodity price movement.

Question 92

Bankruptcy in the United States versus Other Countries

Answer 92

• US Chapter 7 bankruptcy is conceptually (emphasis ours) similar to the bankruptcy procedures followed in most other countries. That is, when a person seeks protection under Chapter 7, that person’s assets are collected and liquidated and the proceeds are distributed to creditors by an appointed bankruptcy trustee. The debtor is normally discharged from the debts that were incurred prior to bankruptcy. As in most other countries, under Chapter 7, rehabilitation of the debtor is not especially important. It is in this sense that the US Chapter 7 is conceptually similar to other countries.
• In contrast, Chapter 11 emphasizes rehabilitation of the debtor and provides an opportunity for the reorganization (restructuring) of the debtor. This is the distinctive feature of US bankruptcy that separates it from most of the rest of the world.
• In Chapter 11, the debtor (a business seeking relief and protection) retains control of its assets (which will immediately pass into a bankruptcy estate under the supervision of the court) and continues its operations. While under this protection, the debtor, now known as a “debtor-in-possession,” seeks to pay off creditors (often at a discount) over a period of time according to a plan approved by the bankruptcy court. Some of the liabilities may be discharged. By filing Chapter 11, a debtor can protect its productive assets from being seized by creditors and have time to plan the turnaround of the business.
• A plan of reorganization is submitted to the court for approval. The plan is typically proposed by the debtor with the blessings of creditors, especially the senior creditors. In most cases, the debtor works with its creditors to formulate a plan of reorganization. This plan details how much and over what period of time the creditors will be paid. Prospective distressed securities investors should pay attention to the exclusivity period. The exclusivity period occurs at the beginning of each case. During this time (set at 120 days but often extended by the court), only the debtor can file a plan of reorganization. After the exclusivity period expires, any party with an interest in the bankruptcy can file a plan proposing how the estate’s creditors are to be paid under Chapter 11. Creditors and shareholders of the debtor eventually must approve the plan and have it confirmed by the bankruptcy judge. The judge can refuse to confirm a case if the plan is not proposed in good faith or if each creditor receives less than it would receive in a Chapter 7 liquidation. The judge can overrule the disapproval by some dissenting creditors, however, on economic grounds or for other considerations, such as social or legal grounds. This is commonly referred to as the “cram down.” Thus, a cram down is basically a compromise between the debtor and certain classes of creditors when they cannot come to an agreement on the reorganization plan. Referred to as the “impaired class,” those who object to the reorganization plan are those who believe their interest in the reorganization is impaired by the proposed plan.
• Put another way, an approved reorganization plan by the court of law may not necessarily make economic sense, and such an erroneous presumption may be costly to distressed investing. The uncertain nature of the outcome of legal proceedings makes analysis of such investment challenging, and it must be accompanied by extensive due diligence.

Question 93

Indirect investment in Real Estate

Answer 93

Indirect investment includes investing in:

• companies engaged in real estate ownership, development, or management, such as homebuilders and real estate operating companies
• real estate investment trusts (REITs), which are publicly traded equities representing pools of money invested in real estate properties and/or real estate debt;
• commingled real estate funds (CREFs), which are professionally managed vehicles for substantial commingled (i.e., pooled) investment in real estate properties;
• separately managed accounts, which are often offered by the same real estate advisors sponsoring CREFs; and
• infrastructure funds, which in cooperation with governmental authorities, make private investment in public infrastructure projects—such as roads, tunnels, schools, hospitals, and airports—in return for rights to specified revenue streams over a contracted period.
• Equity REITs* own and manage such properties as office buildings, apartment buildings, and shopping centers. Shareholders receive rental income and income from capital appreciation if the property is sold for a gain. Mortgage REITs own portfolios in which more than 75 percent of the assets are mortgages. Mortgage REITs lend money to builders and make loan collections; shareholders receive interest income and capital appreciation income from improvement in the prices of loans. Hybrid REITs operate by buying real estate and by acquiring mortgages on both commercial and residential real estate.
• CREFs* include open-end funds and closed-end funds (i.e., funds that are closed to new investment after an initial period). In contrast to open-end funds, closed-end funds are usually leveraged and have higher return objectives; they operate by opportunistically acquiring, repositioning, and disposing of properties.

Question 94

Lock-up period of hedge funds

Answer 94

During this time, the investor cannot redeem any part of the investment. Additionally, once the lock-up period has expired, redemption rights may be limited to a quarterly or semiannual schedule and the investor generally must give advance notice, ranging from 30 to 90 days, of an intention to redeem.

Question 95

Diversification within Real Estate Itself

Answer 95

• The property types that have higher levels of embedded risk, such as large office assets, have generated lower risk-adjusted returns than other sectors and are likely to have more pronounced market cycles. Conversely, those sectors that offer higher risk-adjusted returns, such as apartments, appear to be less volatile and offer more defensive characteristics.
• Targeting the apartment sector of the commercial real estate market over the last decade would have yielded better results than simply diversifying across all sectors. The higher returns of apartment real estate can be partially explained by a low correlation with inflation.
• Equity real estate returns generally have been found not to follow a normal distribution, in US markets and elsewhere, for both the direct investments and indirect investments. Furthermore, the direct market exhibits a high degree of persistence in returns (positive following positive and negative following negative), whereas the indirect market does not show such persistence.

Question 96

Investment Characteristics of Managed Futures

Answer 96

• Derivative markets are zero-sum games. As a result, the long-term return to a passively managed, unlevered futures position should be the risk-free return on invested capital less management fees and transaction costs. For derivative-based investment strategies like managed futures to produce excess returns, on average, there must be a sufficient number of hedgers or other users of the markets who systematically earn less than the risk-free rate. Hedgers, for example, may pay a risk premium to liquidity providers for the insurance they obtain. If that condition is met, managed futures may be able to earn positive excess returns (i.e., be the winning side in the zero-sum transactions).
• Most actively managed derivative strategies follow momentum strategies. In equity markets, research has begun to support the notion that short-term momentum-based strategies may be able to produce excess returns; the evidence related to the market opportunity in futures markets is less well developed.
• Because of the ease with which futures traders take short positions, futures traders can attempt to earn positive excess returns in falling as well as rising markets.
• Because managed futures can replicate many strategies available to a cash market investor at a lower cost—and allow strategies that are unavailable to cash investors—factor models for this group must include the factors that may be unique to managed futures and hedge fund trading opportunities. To the degree that different factors explain managed futures returns and stock/bond returns, managed futures may provide investors exposure to unique sources of return. The presence of such risk factors also provides an economic rationale for managed futures’ diversification capabilities when added to a portfolio of equities and bonds.

Question 97

Among the reasons for including commodities in a portfolio are?

Answer 97

Among the reasons for including commodities in a portfolio are that they are:

• “natural” sources of return (i.e., related to economic fundamentals) over the long term, as discussed above, and
• providers of protection for a portfolio against unexpected inflation.

Question 98

High-water marks and drawdowns

Answer 98

The high-water mark of the fund—that is, the highest previous NAV.

Typically, drawdowns (declines/losses in net asset value) must be recouped before any incentive fees are charged.

Question 99

Performance Appraisal Measures

Answer 99

The Sharpe ratio has a number of limitations that the hedge fund investor needs to understand:

1. The Sharpe ratio is time dependent; that is, the overall Sharpe ratio increases proportionally with the square root of time. An annual Sharpe ratio will therefore be (12)^0,5 bigger than a monthly Sharpe ratio if returns are serially uncorrelated.
2. It is not an appropriate measure of risk-adjusted performance when the investment has an asymmetrical return distribution, with either negative or positive skewness.
3. Illiquid holdings bias the Sharpe ratio upward.
4. Sharpe ratios are overestimated when investment returns are serially correlated (i.e., returns trend), which causes a lower estimate of the standard deviation. This occurs with certain hedge fund strategies that may have a problem with stale pricing or illiquidity. Distressed securities may be an example.
5. 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.
6. The Sharpe ratio has not been found to have predictive ability for hedge funds in general. Being a “winner” according to the Sharpe ratio over a past period cannot be relied on to predict future success.
7. The Sharpe ratio can be gamed; that is, the reported Sharpe ratio can be increased without the investment really delivering higher risk-adjusted returns.