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Alternative Investments: Benefits, Risks, and Structure - Coggle Diagram
Alternative Investments: Benefits, Risks, and Structure
“INTRODUCTION TO ALTERNATIVE INVESTMENTS”
“WHAT ARE ALTERNATIVE INVESTMENTS?”
ALTERNATIVE STRATEGY FUNDS
“Alternative strategy funds have fewer or no regulatory restrictions on the use of short selling, leverage, and derivatives, in contrast to conventional mutual funds”
“greater flexibility to invest in illiquid investments”
strategies
Relative value
“ profit by exploiting discrepancies in the pricing of related stocks, bonds, or derivatives.”
Event-driven
“corporate transactions including mergers, consolidations, restructurings, tender offers, shareholder buybacks, and other capital adjustments.”
Directional
“profit from anticipated movements in the prices of assets ”
“such as bonds, equities, foreign currencies, and commodities”
ALTERNATIVE ASSETS
“Alternative assets are real assets held directly or indirectly”
Commodities
“agricultural products, precious and industrial metals, and energy products.”
“have a positive correlation with inflation. These characteristics support the idea that commodities can exhibit real, inflation-adjusted returns.”
Real estate
“Real estate refers to land or any of the fixed assets built on it, such as buildings, houses, or factories”
REIT (real estate investment trust)
“Real estate becomes a liquid investment when it is securitized – that is, when shares in a pool of real estate assets are resold to investors”
2 forms
Physical real estate
securitized real estate
Collectibles
“rare and unique manufactured or handcrafted objects”
“fine art, classic automobiles, rare stamps, and coins”
high-net-worth world
Infrastructure
“roads, ports, airports, and water works”
Natural resources
Timberland & farmland
“Farmland investments can be accessed privately through private funds, mutual funds, hedge funds, exchange-traded funds (ETFs), REITs, and publicly traded corporations”
“timber assets controlled by timber investment management organizations (TIMOs) have increased.”
PRIVATE EQUITY
“Private equity includes the common stock, preferred stock, and debt securities of firms that typically are not publicly traded, ”
“Private equity investments may include leveraged buyouts, growth capital, turnaround investments, venture capital, mezzanine financing, and the purchase of distressed debt.”
“INVESTING IN ALTERNATIVES – BENEFITS AND RISKS”
“WHY INVEST IN ALTERNATIVE INVESTMENTS”
“To diversify the portfolio”
“Reduced volatility through a more stable net asset value (NAV) for the overall portfolio
• Downside protection in periods of market stress through reduced drawdowns
• Greater allowance for leverage, which can offer higher expected returns”
“A well-diversified portfolio carries with it less risk and therefore is able to safely take on more leverage relative to portfolios that are poorly diversified.”
To add alpha
“Alpha is added by incrementally increasing risk-adjusted returns”
“alpha is a measure of the manager’s performance”
“The greater the alpha, the more value the manager added, and therefore the better they have performed”
alpha: 0 : “the manager has achieved only normal performance”
alpha: negative :“underperformed for the level of risk taken on”
“alternative managers are generally able to produce higher risk-adjusted returns relative to conventional managers”
“To increase the portfolio’s absolute return nature”
EFFICIENT FRONTIER
“makes the portfolio more resistant to capital erosion in the market.”
“One of an investor’s most important decisions to make is the asset allocation or asset mix decision. Studies have shown that between 40% and 90% of a portfolio’s volatility can be explained by the asset allocation, rather than security selection.”
“The curve that reflects the most efficient portfolios for all levels of risk is called the
efficient frontier
.”
“All points below the efficient frontier are inefficient in the sense that by moving a portfolio up to the frontier”
“ combine the lowest level of risk with the highest expected return at that level of risk”
Example figure 20.1
“Conservative investors who have avoided stocks could therefore benefit from some stock exposure”
“The efficient frontier with, for example, hedge funds is preferable to the efficient frontier without hedge funds, because it offers additional portfolio diversification possibilities.”
figure 10.2
“
Modern portfolio
theory provides the tool to make the asset allocation decision. By combining various asset classes such as cash, bonds, equities, and non-correlated alternative investments, an investor can construct an efficient portfolio that maximizes the expected return for each level of risk in a combined portfolio (diversification).”
EMPIRICAL EVIDENCE
“hedge funds performed very well, relatively speaking, during times of extreme stress in the traditional markets. This was especially true between 2008 and 2010 and during the first half of 2020”
“Conversely, hedge funds performed relatively poorly when traditional investments were performing very well during the 2013 – 2019 period”
“over the past 15 years until the end of 2019, they have generally outperformed traditional investments when traditional investments were performing poorly, such as during the 2004 – 2012 period.”
“Hedge funds also provide some degree of downside protection to the portfolio’s NAV, particularly during periods when traditional investm
WHAT IS RISK?
volatility
“Deciding on portfolio allocation to alternative investments utilizing an efficient frontier (discussed immediately above), and
When calculating risk-adjusted return measures such as the Sharpe ratio, first introduced in Chapter 16 of this course”
“the fund’s drawdown amount”
“ maximum percentage decline in the alternative fund’s NAV over a specified time period”
“ALTERNATIVE STRATEGY RISK DRIVERS”
FIRST-ORDER RISKS
“The source of risk is the market itself, and the risk is systematic, meaning that it cannot be reduced through diversification”
“does not affect relative value strategies or event-driven strategies to any significant degree. It does, however, affect directional strategies”
“are based on an alternative strategy fund manager’s views about the direction of different markets, interest rates, commodity prices, and currencies.”
“relate to the exposure to changes in the general direction of equity, fixed income, currency, and commodity markets.”
SECOND-ORDER RISKS
“include liquidity, leverage, deal break, default, counterparty, trading, concentration, pricing model, and trading model risks”
“these risks are not related to the market, but to other aspects of
trading
,
such as dealing, implementing arbitrage structures, and pricing illiquid or infrequently valued securities”
see table 20.1 definition of the second-order risk
Liquidity risk
Leverage risk
“loss on a position financed with borrowed money”
Deal breakage risk
Default risk
Counterparty risk
“The risk that the counterparty to an over-the-counter (OTC) agreement will not fulfill its obligations”
“Over-the-counter agreements are private transactions between two counterparties. ”
Trading risk
“The risk of receiving a poor fill price based on unexpected delays in execution”
Concentration risk
Pricing model risk
“Many hedge funds value their complex or illiquid positions using a model rather than a market price. These models are based on assumptions, which can lead to erroneous valuations if the assumptions are incorrect.”
Trading model risk
“Some alternative strategy fund managers base their trading decisions on a systematic model that was tested on historical data”
OPERATIONAL RISK
“Operational risk relates to the alternative strategy fund as a business entity”
“alternative strategy funds can be small, newly created businesses that depend on one or more high-profile managers for their success. Such organizations are highly focused on promoting and supporting the skills of the manager or managers”
“may lack the organizational depth, managerial talent, and strategic planning capabilities necessary to ensure growth”
for alternative strategy funds:
operational risk stems from potential system failures as well as faulty settlement, reporting, and accounting procedures
ALTERNATIVE INVESTMENT STRUCTURES
“EXEMPT MARKET ALTERNATIVE FUNDS (HEDGE FUNDS)”
Lightly regulated; hedge fund manager has tremendous flexibility
“a hedge fund as a type of fund structure, rather than a particular investment strategy.”
“Hedge funds do not have a unique legal structure”
“Some hedge funds are conservative, while others are more aggressive”
recent regulatory changes in Canada : inclusion of alternative investment strategies under modified mutual fun regulations
does not impact existing regulatory exemptions for exempt /accredited investors and minimum initial investment exemption (i.e. hedge funds)
“WHO CAN INVEST IN HEDGE FUNDS?”
“Securities regulators permit the sale of securities without a prospectus, but only under certain conditions and only to investors who meet exempt investor qualifications”
There are 3 common prospectus exemption allowed by security regulators
“Minimum investment exemption;
“the sale of securities without a prospectus to non-individual investors who make a prescribed minimum investment. National Instrument 45-106 (NI 45-106) sets this
minimum at $150,000
across all jurisdictions in Canada.”
• Accredited investor exemption;
Institutional
“Generally includes entities such as
pension funds, trust companies and corporations with net assets of at least $5 million
”
individuals
owns financial assets with an aggregate realizable value (before tax, but net of related liabilities) that
exceeds $1 million
“financial assets would include cash, deposits, bonds, and public equities, but would
not include real estate
.”
“individual whose
net income before taxes exceeded $200,000
(or
exceeded $300,000 if combined with a spouse
’s income) in each of the two most recent years”
“who has a reasonable expectation of exceeding that same income level in the current year”
“An individual who, alone or with a spouse, has net assets (which would
include real estate, and which is again net of any related liabilities) worth at least $5 million
.”
“must obtain a completed and signed risk acknowledgement form from the individual accredited investor.”
• Offering memorandum exemption” :red_flag:
“If an issuer prepares an offering memorandum in the prescribed form and it is delivered to the purchaser before the purchase, a prospectus is not required”
“The offering memorandum must follow a prescribed form and provide for the rights of rescission or a right of action, if these are not available by regulation. Included in the expected prescribed disclosure is information regarding the issuer and audited financial statements.”
“In some provinces and territories (
Manitoba, Northwest Territories, Nunavut, P.E.I., and Yukon
), the
offering memorandum exemption is subject to a limit of $10,000
, unless the purchaser is an eligible investor.”
“In other provinces (
Alberta, New Brunswick, Nova Scotia, Ontario, Quebec and Saskatchewan
) the exemption is subject to similar monetary limits as noted below and also subject to an
overall purchase limit on an annual (preceding 12 months) basis
”
“the amounts noted below must not have been exceeded over the last 12 months in order for the exemption to apply”
“In the case of a purchaser that is
not an eligible investor, $10,000
;
• In the case of a purchaser that is a
n eligible investor, $30,000
; and
• In the case of a
purchaser that is an eligible
investor and that
received advice from a portfolio manager, investment dealer or exempt market dealer t
hat the investment in question is suitable,
$100,000
.”
“A
n eligible investor has a lower financial threshold than an accredited investor but requires a confirmation of suitability from an eligibility advisor who is a registered investment deale
r.”
HEDGE FUND FEATURES
INCENTIVE FEES
“Incentive fees are usually calculated
after management fees and expenses are deducted
, rather than on the gross return earned by the manager”
managers may be driven by self interest rather than the interest of the fund
“The calculation of incentive fees can be subject to a high-water mark or a hurdle rate, or both”
High-water mark
“A high-water mark ensures that a fund manager is paid an incentive fee only on net new profits”
Hurdle rate
“A hurdle rate is the rate a hedge fund must earn before its manager is paid an incentive fee”
“For example, if a fund has a hurdle rate of 5%, and the fund earns 20% for the year, incentive fees will be based only on the 15% return above the hurdle rate, subject to any high-water mark. Hurdle rates are usually based on short-term interest rates.”
HEDGE FUND LIQUIDITY
“all hedge funds are less liquid than say mutual funds (or alternative mutual funds) because they are priced and traded less frequently”
are priced at the end of each month(no money can be added or withdrawn from the fund except at the end of each month)
“some funds have monthly subscriptions and quarterly redemptions with 30 days’ notice required before redemption”
lockup period
hard lockup period
not allowed to redeem for any reasons
soft lockup period
“investors can redeem their investments before the end of the lockup period by paying a fee.”
“some hedge funds may delay redemption requests even after investors have satisfied the lockup period”
FUND TRANSPARENCY
product transparency
The level of detail provided
The frequency of communication
The time between the fund reporting date and the date when the info is communicated to investors
“ETF holdings are communicated with a
one-day delay”
“conventional mutual funds are required to provide a detailed fund holding report
on a quarterly basis
”
“For hedge funds sold in the exempt marketplace, information regarding fund holdings and activity might only be reported semi-annually, and often with a
90-day delay
”
INVESTOR PROTECTION
conventional mutual fund & alternative mutual fund investors
“cancel their investment without penalty
within a two-business
day period after they have received confirmation”
“ETF purchases do not have a right of withdrawal”
“only applies to hedge funds if stipulated in the offering memorandum”
“ALTERNATIVE MUTUAL FUNDS (LIQUID ALTS)”
“Canadian Securities Administrators (CSA) modernization of Investment Product Regulation (NI 81-102)”
“allow retail investors increased access to alternative strategies through a type of mutual fund known formally in the regulation as alternative mutual funds”
“Commodity Pools that were in existence prior to the regulatory change automatically became alternative mutual funds when the CSA modernization amendments came into force on January 3, 2019. They had until July 4, 2019 to comply with the new rules applicable to alternative mutual funds.”
conventional mutual funds
daily liquidity
good transparency
attempted to earn the highest relative returns versus its peers
Hedge funds
very limited liquidity
very limited transparency
strived to earn absolute (positive) returns regardless of market conditions
Alternative mutual funds
combination of conventional mutual funds and alternative investments
provide retail investors with benefits
“Access to investment strategies that were previously largely available only to exempt investors
• The goal of earning absolute returns during all phases of a market cycle
• The transparency, daily liquidity, and investor protection rights that are associated with conventional mutual funds (despite the ability of alternative funds to engage in riskier and potentially higher return strategies)
• Considerably lower minimum investment required in comparison to hedge funds”
“Low fees, generally, in comparison to hedge funds”
“According to the Alternative Investment Management Association (AIMA),
the average performance fee for alternative mutual funds is around 8%
, compared with
fees as high as
10%-to-20% for hedge funds
. Both hedge funds and alternative mutual funds also charge
management fees, generally in the 1%-to-2% range
.”
“As with conventional mutual funds, liquid alternatives can only invest up to 10% of the fund’s NAV in illiquid assets (based on NI 81-102)”
“Some examples of illiquid assets include penny stocks, ownership interests in private companies, collectibles like art and antiques, and some types of bonds and debt instruments”
“FUNDS OF HEDGE (OR LIQUID ALTS) FUNDS”
“both hedge funds and liquid alts are able to invest up to 100% of their net assets in other mutual funds (including alternative mutual funds) ”
fund of hedge funds(FoHF) : a fund of liquid alt funds
“An FoHF is a portfolio of hedge funds overseen by a manager who determines which hedge funds to invest in and how much to invest in each”
2 main types
“Single-strategy, multi-manager funds invest in several funds that employ a similar strategy, such as long or short equity funds and convertible arbitrage funds.
• Multi-strategy, multi-manager funds invest in several funds that employ different strategies.”
“ADVANTAGES OF FUNDS OF HEDGE FUNDS”
Due diligence
Reduced volatility
Professional management
Access to hedge funds
Ability to diversify with a smaller investment
“accept as little as $25,000 from accredited investors”
“ some funds have a minimum investment threshold of US$1 million, with some as high as US$5 million or more”
Manager and business risk control
“DISADVANTAGES OF FUNDS OF HEDGE FUNDS”
Additional costs
“1% management fee and a 10% incentive fee, plus fund expenses.”
No guarantees of positive returns
Low or no strategy diversification
Insufficient or excessive diversification
Additional sources of leverage
“EXCHANGE-TRADED FUNDS (ETFs)”
“Certain ETFs, like leveraged and inverse products, were regulated under NI 81-104 and as such have been already allowed a certain degree of flexibility with respect to derivatives and leverage (but not short selling of non-derivative securities)”
“liquid alternative ETFs have grown in number and market share and now comprise slightly less than 10% of all liquid alternative investments.”
“One of the main advantages of ETFs versus hedge funds or liquid alts is the ability to trade them intra-day on an exchange”
“COMPARING ALTERNATIVE MUTUAL FUNDS WITH CONVENTIONAL MUTUAL FUNDS AND HEDGE FUNDS”
alternative mutual funds (liquid alts): short sell up to maximum 50%; an overall leverage limit of 300% of NAV;
mutual funds: short sell up to maximum of 20%;
hedge funds: higher leveraged limit
conventional mutual funds: require a 100% cash cover, leverage is prohibited
“KEY DIFFERENCES BETWEEN CONVENTIONAL MUTUAL FUNDS AND ALTERNATIVE FUNDS”