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Reading 50: Introduction to Alternative Investments - Coggle Diagram
Reading 50: Introduction to Alternative Investments
Difference from Traditional Investments
Different types of assets held, structure of investment vehicles
Higher fees (management, incentive)
Less liquid
Less regulated, less transparent
Different tax treatments
More concentrated portfolios
Redemption restrictions
Categories of alternative investments
Hedge funds
Charateristics
Limited to qualified investors
Lockup period: Minimum time before investor can withdraw funds
Notice period: Days within which a fund must fulfill a redemption request
Investment companies structured as limited partnerships, use leverage, derivatives, short selling
Loss is magnified by margin call: Have to liquidate losing position to meet margin call, thus exacerbate the loss
Strategies
Event-driven strategies
Merger arbitrage: buy shares of firm being acquired, short shares of acquirer
Distressed/ restructuring: buy if restructuring will increase value
Activist shareholder: Gain board seats to influence company decisions
Special situations: Spinoffs, asset sales, security issuance or repurchase
use bottom-up approach and seek to profit from short-term event
Relative value strategies
Convertible arbitrage: Convertible bonds vs. underlying common stock
Asset-backed: ABS, MBS
General fixed income
Volatility: Trade options based on implied versus expected volatility
Multi-strategy: Across asset classes
Macro strategies
Trade securities, currencies, commodities based on global economic trends
Equity hedge fund strategies:
Market neutral: Equal values in long and short positions
Fundamental growth: Identify high-growth companies
Fundamental value: Identify undervalued companies
Quantitative directional: may have net long or short exposure
Short bias: Net short exposure
Fund of funds:
invest in multiple hedge funds.
Valuation
Should use bid prices for long positions, ask prices for short positions
Values of non-traded securities estimated with pricing models
Illiquid securities
Reduce market price to account for illiquidity based on size of position held
Trading NAV is adjusted for illiquidity
Hedge Fund Fees:
2 and 20%: 2% management fee AND 20% incentive fee
Incentive fee is charged by a fund manager based on fund's performance over a given period. The fee is usually compared to a benchmark
Management fee may be calculated on beginning or ending assets
Incentive fee may be
Net of management fees: Incentive fee = (Ending Capital - Beginning Capital - Management Fee) x Incentive Fee
independent of management fees: Incentive Fee = [Ending capital - Beginning capital ] x Incentive Fee
Fund of funds typically charges 1 and 10 in addition to fees paid on underlying hedge fund investments
Hurdle
Hard hurdle rate: Incentive fees only on gains above hurdle rate
Soft hurdle rate: Incentive fees on all gains, but only if return exceeds hurdle rate.
High water mark:
Incentive fees only on gains that increase assets above the high watermark value (net of or independent of management fee)
If so, incentive fee is calculate based on high water mark level, not the beginning capital level
Example:
Management fee: 5%, incentive fee 20% over the 8% hurdle amount. Original fund: 250 mil, appreciated 16% at the end of year.
End of year capital: 250 x 1.16 = 290 (mil)
Management fee: 290 x 0.02 = 5.8 (mil)
Hurdle amount: 250 x 0.08 = 20 (mil)
Incentive fee: (290 - 250 - 20 - 5.8) x 0.2 = 2.84 (mil)
Investor net return: (290 - 250 - 5.8 - 2.84)/250 = 12.54%
Private equity
Invest in private companies or take public companies private
Private equity strategies
Leveraged buyout (LBO):
Most common private equity strategy
Funded by debt
Bank debt, high yield bonds
Mezzanine financing: subordinated debt, includes warrants or conversion to equity
Types
Management buyout (MBO): Current managers involved in purchase, remain with company
Management buy-in: Replace managers of acquired company
Venture capital:
Invest in a company at the early stage
Stages
Formative stage:
A. Angel investing: Business plans, market potential
B. Seed stage: Product development, market research. Most common to receive venture capital fund
C. Early stage: Begin production and sales
Later stage:
Company expansion
Mezzanine stage:
Prepare for IPO
Structure and Fees
Typically structured as limited partnership
Investors provide committed capital which fund managers draw down to invest in portfolio companies.
management fee is based on committed capital
Management fees typically 1% to 3% of committed capital
Inventive fees typically 20% of profits
Fees paid periodically may exceed 20% over time.
Clawback provision requires managers to return any funds distributed as incentive fees, until the investor has received back initial investment plus a contracted portion of total profit.
Exit strategies
Trade sale: Sell portfolio company to competitor
Secondary sale: Sell portfolio company to other private equity investors
IPO: Sell portfolio company shares to public
Recapitalization: Issue portfolio company debt to fund dividend payment (to private equity owner)
Write-off / liquidation: Take loss
Developmental capital / minority equity / private investment in public equity (PIPE)
Distressed investing
Valuation
Same techniques used to value publicly traded companies are used to value private equity portfolio companies
Market / comparables approach
Discount cash flow approach
Asset-based approach
Private companies may require different discount rates or price multiples than publicly traded companies
Real estate
Categories
Residential property
Commercial property
Mortgages, mortgage-backed securities
Real-estate investment trusts (REITs)
Farmland, timberland
Infrastructure security (Exchange-traded MLP)
Valuation
Comparable sales approach:
recent sales of similar properties
Income approach:
Present value of future cash flows from property
=\(\frac{Net.Operating.Income}{Capitalization.rate}\)
cost approach:
Replacement cost, including land and current costs to rebuild
Real Estate Investment Trust (REITs) valuation
Income based: Similar to direct capitalization
Funds from operations (FFO)
Adjusted funds from operation (AFFO)
Capitalization rates
Asset-based approach:
calculate a REIT's NAV = \( \frac{Total.Asset - Total.Liabilities}{No.Share.Outstanding}\)
Repeat sale index
Repeat-sales method assesses how house valuations change over time by focusing on the different sale prices of the same piece of real estate.
susceptible to sample selection bias
Commodities
Commodities exposure most commonly gained through derivatives rather than outright ownership
Return comes from price changes (no income)
Hedge against inflation risk
Categories
Commodity ETFs: available to investors who are restricted to equity shares
Shares of commodity producers: less-than-perfect correlation with commodity prices.
Managed futures funds: active management of commodity investments
Individual managed accounts
Commodity sector funds
Valuation
cost-of-carry model
Futures price = Spot price x (1 +Rf) + storage costs - convenience yield
Convenience yield: value of having physical commodity available for use
Low convenience yield → Contango, F > S; roll yield = F - S
High convenience yield → backwardation, S >F
Infrastructure
Long-lived assets that provide essential public services.
Economic infrastructure
transportation (road, bridge, airports)
utility assets (pipelines, waste treatment, communications)
Social infrastructure
(schools, hospitals, prisons)
categories
Direct vs. Indirect
Direct investment:
Large size, low liquidity, must operate and maintain physical assets
Indirect Investment:
Publicly traded infrastructure securities
Master limited partnership
Shares of firms
Exchange-traded funds
Listed mutual funds
Private equity funds
Unlisted mutual funds
Brownfield vs. Greenfield
Brownfield investment
Invest on existing projects
have less risk and lower expected return
Greenfield investment
Invest on yet-to-be-built infrastructure
higher risk but higher return
Regulatory risk is inherent to infrastructure investment
Others
(e.g., collectibles, patents)
Benefits of Alternative Investments
To improve the risk/return profile of the overall portfolio
Hedge funds and private equity have had higher Sharpe ratios than global equities
HOWEVER
Return measures for alternatives are
less reliable than traditional asset classes
reflect risk specific to alternative investments
lack of liquidity & transparency
restrictions on redemptions
choice of managers
Risk management
Standard deviation is not the most appropriate measure for derivatives
WORSE PAIRING: Fat tails (leptokurtosis) , negative skewness
Return smoothed by model or appraisal asset valuations
Measure of DOWNSIZE RISK
Maximum losses over various periods
Sortino ratios: use standard deviation only of returns below the target ratio
Sharpe ratios, Sortino ratios, and measures of downsize risk do not consider diversification benefits or provide estimates of optimal allocation
Diversification benefits are not always realized
Correlations increase during financial stress and can approach one during financial crises
Problems
Risks from use of derivatives (counterparty, illiquidity, operational, financial risk)
Performance depends on manager's skill (manager selection risk)
Lack of transparency
Illiquidity
Correlations with traditional investment returns vary over time