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Alternative Investments: Benefits, Risks & Structure - Coggle Diagram
Alternative Investments: Benefits, Risks & Structure
Introduction
Traditional MF = usually retail; long positions (buy & hold); best benchmark/relative return; highly regulated under NI 81-102; daily redemptions
Hedge fund = high net worth & institutional investors; uses short selling / leverage / derivatives; absolute returns; looser regulation; lock up periods so limited flexibility
Alternative Investments
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lets retail investors (non accredited) have access to hedge fund like strategies - within mutual fund regulatory framework
HF - flexible but restricted to wealthy; AMF - regulated but open to all (can use leverage, short selling, derivatives like HF but for retail investors within MF regulations)
categories
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alternative assets (owned directly like owning asset physically or indirectly like future or derivatives)
commodities = basic goods (oil, gold, metals); low / negative correlation with traditional assets; positive correlation with inflation (good inflation hedge)
real estate = land buildings; direct (own property) or indirect (by owning REITs -- liquid real estate investments); residential / commercial / industrial
collectibles = tangible items (arts, cars, coins, stamps); illiquid & used by wealthy; can be manufactured (classic car) or hand crafted (paintings)
infrastructure = roads / airports / utilities; long term projects funded by investors; stable cash flow
natural resources = farmland & timberland (areas owned by people to grow forests later to cut and sell wood); farmland - income from tenant farmers + land appreciation; timberland -- low correlation with traditional assets, controlled by Timner Investment Management Organizations (TIMO)
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Benefits
diversification = adding alts brings in new assets with low or negative correlation to traditional one; reduced volatility, downside protection, greater use of leverage; real estate rises in inflation so offsets losses from bonds/stocks
adding alpha = value manager adds beyond what's expected; + (outperformed expectations); 0 (same as expectations); - (underperformed expectations); ex-- expected return 6% actual return 7% alpha is +1% (so manager outperformed); zero alpha -- no excess performance
flexibility of alt investments = use short selling / leverage; invest in illiquid assets; target absolute returns; improve returns with advanced strategies; increase pf returns
asset allocation = 40-90% pf volatility comes from asset allocation choices not picking individual stocks; pf of 100% bonds might be riskier than one split across bonds stocks eqs and cash
efficient frontier = curve that relates risk as standard deviation with performance; shows most efficient pf; arrange all the pf given to you in ascending order of risk % - with increasing risk% the % return should go up too if not that pf is sus; point on curve - best return for that risk, point below curve - too much risk for return (inefficient), moving up the curve - improve return without adding risk; x axis - risk measured by standard deviation; y axis - expected return
empirical evidence = history shows adding alts improves performance during volatile times; HF Lalts perform better when markets fall
Risks
chance of an investment's value moving away from expected; measured using standard deviation (measures volatility - measures risk in efficient frontier & sharpe ratio) & drawdown amount (% fall in fund's value over period)
first order risk = market risk - entire market can fall down; eq drops fund value drops too; cant be diversified away
second order risk = other dangers that affect returns remember as 'lazy lions dont chase cats they prefer trading optimally'
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Structure
Hedge Funds
exempt market alt funds
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lightly regulated, allows flexible strats; NI 45-106
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who can invest
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accredited investor exempt = institutions (net assets >5Million); individuals (net financial assets > 1million (before debts); net assets > 5million(after debts); income >200k)
offering memorandum exempt = investors sign risk acknowledgement form; manitoba PEI yukon (limit to 10k); ontario alberta (limits of 10k to 100k depending on eligibility & advice received)
features
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high water mark = prevents double dipping; managers have to go beyond previous profits to earn incentive fee; ex if the fund looses money and then comes back to the same amount - investor wont pay manager incentive fee before for the same profit fee was paid earlier - anything over this level is liable for an incentive
hurdle rate = min return manager must achieve before getting incentive fee - if both hurdle & high water mark apply then manager gets paid only on the portion exceeding both
liquidity
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lockup period = hard lockup (no redemption allowed); soft lockup (allowed with fee); can delay during market crisis (2008 crash or COVID)
transparency
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transparency depends on level of detail, freq of reporting, lag time in disclosure
MFs ETFs disclose holdings regularly through prospectus; HFs disclose through offering memorandum so no strict regulation
investor protection
MFs = right of withdrawal within 2 bus days; HFs = rules defined in Offering memorandum; ETFs = no withdrawal rights (traded on exchange)
Liquid Alts
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key differences
traditional MFs = offer daily liquidity; good transparency; relative returns (beat the market benchmark)
liquid alts = limited liquidity; limited transparency; absolute returns (positive returns in any market)
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trade offs / limitations
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limited exposure to private companies, collectibles, long term investments
mostly invests in illiquid investments = penny stocks, private company shares, collectibles, debt instruments
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ETFs
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types = leveraged (multiple underlying indexs return); inverse (move in opposite direction of underlying index)
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