READING 30: ALTERNATIVE INVESTMENTS PORTFOLIO MANAGEMENT (:smiley:AI:…
READING 30: ALTERNATIVE INVESTMENTS PORTFOLIO MANAGEMENT
:smiley:AI: common feature / their markets and how AI added to the portfolio
:checkered_flag: Basic group
Grouped by their roles
Real estate and long-only commodities offer exposure to risk factors and return that
stocks and bonds cannot provide
Hedge funds and managed futures offer exposure to
special investment strategies
and are heavily dependent on
Private equity and distressed securities are seen as a
of 1 and 2.
Common features :monkey_face:
Diversification <<= low correlation
High due diligence cost <<= Specialized expertise and specific business skills
Difficult to evaluate performance <<= lack transparency
Major Due diligence checkpoints :check:
1. :ocean: Access the market opportunities offered
<<= any exploitable inefficiencies in the market for the type of investments which the manager
:twisted_rightwards_arrows: Assess the investment
<< = manager's competitive edge over the others / Process of how the manager identify the opportunities?
:house: Assess the organization <<= stable / well-run / staff- turnover?
:man-woman-boy:Assess the people <<= integrity/ competence
:straight_ruler:Assess the terms & structures of the deals
6.Assess the service providers .
:bookmark:Review documents: Prospectus, IM etc.
Distinctive issues of private wealth clients :face_with_head_bandage:
but not institutions
Tax << = Most individuals must pay taxes =>> require specialized tax expertise
i.e. Complex strategies are not easy to communicate
Decision risk <<= risk of emotionally abandoning a strategy right at the point of maximum loss
Concentrated positions <<= due to preexisting allocation =>> difficult to rebalance when needed
to incorporate AI into traditional portfolio
ALTERNATIVE INVESTMENT CLASSES
Can be directed / indirect invested (Stocks of developers, equity
, mortgage REITS, Commingled real estate funds -
(pro-managed, privately-held pooled investment funds); seperately managed accounts, Infrastructure funds
Advantages: low correlation, low volatility, inflation hedge, tax advantages, potential to leverage return
Disadvantages: high information - transaction cost, political risk, high operating expanses, low return, can have large idiosyncratic risk component
(provide funds to buy existing public companies from their shareholders and then take the company private)
Middle-market buyout funds
(due to their relatively small size, cannot efficiently obtain capital)
Mega-cap buyout funds
(concentrate on taking publicly traded firms private)
Ways to add value : (1) restructuring, (2) buy for less than intrinsic value, (3) restructuring debt
Exit strategies: (1) thru private placement, (2) IPO, (3) Dividend recap ( = issue debt to pay out a large special dividend).
common risk features
low correlation with stocks and bonds
positive correlation with inflation
under the form of
(a) direct investment (physical / derivatives)
(b) indirect investment ( in stocks ).
Derivatives investment is preferred.
A diverse group and
the terminology used to describe them is flexible
Initially they were private pools of money that were both
target an absolute level of return that is
on market returns
Hedge fund classifications include: equity market neutral, convertible arbitrage, fixed-income arbitrage, distressed securities, merger arbitrage hedged equity, global macro, emerging markets, and fund of funds (FOF .
A 2% base fee plus a 20% share of the profits is a common fee structure
considered to be skill based
The primary feature that distinguishes managed futures from hedge funds is the difference in the assets they hold
only trade in derivatives markets.
generally take positions based on indices
Have a macro focus
Hedge funds :
often trade in spot and futures markets
focus more on individual asset price anomalies
have more of a micro focus
One way to construct subgroups in distressed securities is by structure, which determines the level of liquidity.
The hedge fund structure for distressed security investment is more liquid.
The private equity fund structure describes funds that are less liquid
Evaluate return enhancement & risk diversification effect
High risk-adjusted performance
(1) Low liquidity, (2) large lot sizes, (3) immobility, (4) High transaction cost, (5) low info transparency
Typical react to macro changes differently than other asset classes
Each investment has larger idiosyncratic (unsystematic) risk component
Advantages vs. Disadvantages
of direct investment
More leverage than other investment
investors can diversify geographically
High info cost
Lack of divisibility
High operating & maintenance cost
Geographical risk ( neighborhood deterioration)
Political risk (changing tax code)
Benchmarks of real estate
02 main types of RE indices
(REIF and REIT).
Plus, each has an "adjusted" version
unsmoothed NCREIF provides the best data for representing the performance of direct investment in RE
National council of Real estate Investment Fiduciaries Property index (
= performance results of
making direct, unleveraged investment in real estate properties
Unsmoothed REIF is adjusted to
remove the distortions of smoothing
is considered to provide the
representation of the true investmen characteristics of direct RE investing
is a principle benchmark for "direct" RE investing
valued- weighted index"
of commercial RE that uses sample based on geo-location and type . data collected periodically
The index volatility is downward biased
National Association of real estate investment trust (
) index (= index of traded stocks of companies that invest in RE or RE-related assets)
characteristics of public equity and RE, hence not true investment characteristics of RE investing.
those in NAREIT use financial leverage, thus distorting the data.
" data removes the equity-like effect of leverage but still does not provide the best reflection of underlying RE characteristics
and includes all REITs traded on the NYSE or AMEX
unsmoothed data raised the standard deviation
and reduce the Sharpe ratio of the RE investment, making it less attractive, but still a valuable addition to stock/ bond portfolio due to its low correlation
Venture capital investing
@ Formative stage
@ Expansion stage
( seeks opportunities in their own expertise)
Angel Investors (i.e. first outsiders)
Seed money ( to begin prototype works)
start-up (begin product development & MKT)
First- stage funding ( begin manufacturing & sales)
Second stage funding ( further expansion of production and sales)
Third stage funding ( additional major expansion)
Mezzanine / Bridge financing (prepare for IPO)
Earlier / steadier cashflows
Less error in measuring returns ( as based on cashflows)
Less frequent loss
Convertible preferred stocks
First claim on cashflow ahead of founders
Receive a minimum return before shareholders
Offer prior claim in bankruptcy
The conversion ration provide upside participation
Later financing rounds always have priorities over receiving cashflows
Private equity is less of a diversifier and more a long-term return enhancer
Private equity returns typically move with stock market returns
often positive and low ( due to stale price)
Each investment has large idiosyncratic component, yet, provide moderate diversification
exploit mispricings or anomalies in the
price of convertible securities
A common example is to buy undervalued convertible
bonds and short the stock.
Only long, often no derivatives to hedge
Combine long & short positions, to eliminate systematic risk
Hedge Equity strategy
Long & short to exploit mispricings, but not to eliminate systematic risks
Fixed income arbitrage
Global macro strategies
focuses on returns from mergers,
Fund of funds
Funds of funds
FOF : good entry level investment
help achieve diversification
consists several Hedge funds ( 10-30 funds)
Have extra layers of management => extra mgnt fee.
than hedge funds
(-) "cash drag" caused by manager keep extra cash for potential withdrawals
better indicator of aggregate hedge fund
performance ( vs. hedge fund index), as it suffers less from survivorship and backfill bias. ( ie. FOF still includes a failure (ie. dissolved hedge funds) in its return.
(-) suffers from "style drift".
FOF returns has been
more highly correlated with equity
market (vs. those of individuals hedge funds).
hedge funds have no direct benchmark =>> hedge funds are absolute return vehicles.
to create comparable portfolio (i) use a single/ multi-factor models , (ii) create a tracking portfolio that has comparable risk/ return characteristics.
Conventions to consider
longer lock-up, higher return
Younger funds outperform older funds
large funds underperform small funds
returns: comparing ending value to beginning value / rolling return (i.e 12M Moving avg).
leverage: treat an asset as if it was fully paid for.
Risk: Stan.Deviation => misleading due to "fat tails"
Downside deviation: Only count " below threshold return"
The Sharpe ratio (using annualized measures), yet, has
1. time dependency
: eg. to estimate the annual Sharpe ratio for a hedge fund using quarterly returns
the analyst multiplies the quarterly return by 4 and multiplies the quarterly standard deviation by the square root of 4.
Assumes normality: hedge fund returns are usually skewed with significant leptokurtosis (fat tails), but in this case, we incorporate standard deviation are inappropriate for skewed return distributions.
Assumes uncorrelated returns: Returns correlated across time will artificially lower the standard deviation
Stand-alone measure: Does not automatically consider diversification effects.
great deal in composition and even frequency of reporting
no consensus as to what defines hedge fund strategies => differences in indices, style classification
Relevance of past data : If hedge funds are a reflection of manager skill, then past returns for indices is less relevant to future returns since hedge fund indices frequently change
Popularity bias: can result if one of the funds in a value-weighted index increases in value and then attracts a great deal of capital.
Survivorship bias (=>
Stale price bias
Backfill or inclusion bias
Correlations of commodity indices
with bonds: low and even
02 factors affect whether a commodity is a good inflation- hedge
Storability (primary determinant)
Economic activity: whether the commodityߞs demand is linked to economic activity
many indices yet, most of them assumes a
nature of futures, the indices cannot use a market-cap method of weighting
basing weights on world production of the underlying commodities
basing weights on relative worldwide importance
(buy below investment grade)
Orphan equities investing
( buy equities of firms emerging from reorganization)
Distressed debt arbitrage
( Buy the distressed debt + short the equities)
(acquire positions and control)
event risk, market liquidity risk, market risk, J-factor risk (courts / judges), and other types of risk.
high average return but a
large negative skew
=> Sharpe ratios can or average return-to-volatility ratios be
(most relates to Commodity)
typically run by Commodity Pool Operators (CPOs). CPOs can be Commodity Trading Advisor (CTA) and hire from outside.
A commodity trading advisor (
) is an individual or firm who provides individualized advice regarding the buying and selling of futures contracts, options on futures or certain foreign exchange contracts
much like a financial advisor
, except that the CTA designation is specific to providing advice related to commodities trading
CTA requires registration to give advice regarding
all forms of commodity investments,
including futures contracts, forwards, options, and swaps.
that uses futures contracts to achieve its investment objective.
CTA funds use a variety of trading strategies to meet their investment objectives, including
systematic trading and trend following (discretionary trading strategy)
correlations with equities
among CTAs themselves
can range anywhere from significantly positive (i.e., close to 1.0) to only modestly positive.
beta that relates the performance of an individual CTA to a fund of CTAs can be a good indicator of
future risk-adjusted performance.
Notes: Benchmarks are available for commodities, real estate, private equity, and hedge funds, though not all of them are easy to interpret.
Stocks & bonds as a core
AI as the sateliite (to seek alpha)