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<!doctype html>
<html lang="en">
<head>
<meta charset="utf-8">
<title>Study Session 13 | Reading 31 | Alternative Investments</title>
<meta name="description" content="Chartered Financial Analyst Level 3 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<body>
<div class="reveal">
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<div class="slides">
<section>
<h1>Reading 31</h1>
<h3>Alternative Investments</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">Alchemists Academy</a> by <a href="http://alchemistsacademy.com/about">MacLaneWilkison</a></small>
</p>
</section>
<section>
<h2>Overview</h2>
<ol>
<li>Private Equity and Venture Capital</li>
<li>Real Estate</li>
<li>Commoditites</li>
<li>Hedge Funds</li>
<li>Managed Futures</li>
<li>Distressed Securities</li>
</ol>
</section>
<!-- Example of nested vertical slides -->
<section>
<section>
<h2>Private Equity and Venture Capital</h2>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: An ownership interest in a private company</em></p>
<ul>
<li>Private placemements</li>
<li>Leveraged buyouts (LBO)</li>
<li>Venture Capital (VC)</li>
</ul>
<aside class="notes">
There are many different types of private equity funds: distressed debt, public infrastructure, private investment in public equities (PIPEs). LBOs are buyouts of established companies, using debt issued by the target. VCs provide equity financing to new and/or growing private companies
</aside>
</section>
<section>
<h2>Venture Capital</h2>
<p>Demand: Early-stage (seed/start-up) and later-stage</p>
<p>Supply: Angels, venture capital firms, corporate venturing</p>
<aside class="notes">
Seed stage companies are little more than an idea and often are financed by the 3 F's (friends, family, and fools). Start-ups are a little more mature and, while still pre-revenue, may be in the process of building the product or service and preparing for commercialization. In recent years, the supply-side ecosystem has continued to eveolve with acceleratiors/incubators like Y-Combinator and Techstars providing another source of financing for early stage-companies. Later-stage companies are primarily concerned with finding product market fit and expanding sales. Angels are HNWI, ideally with a set of contacts and/or expertise that can aid the company. VCs are professional investors with significant expertise in both operating and financial matters. They often take representation on the BoD and receive convertible preferred equity in exchange for their capital investment. The ultimate goal (possibly excluding corporate venture departments) for an investor is to monetize their stake via an exit event such as an IPO or acquisition.
</aside>
</section>
<section>
<h2>Buyout Funds</h2>
<ul>
<li>Acquire significant stakes in established companies</li>
<ul>
<li>Mega-cap vs. middle-market</li>
</ul>
<li>Value creation</li>
<ul>
<li>Operational restructuring/improved management</li>
<li>Acquisitions at a discount to intrinsic value</li>
<li>Financial engineering</li>
</ul>
</ul>
<aside class="notes">
Mega-cap funds take large and/or public companies private while middle-market funds specialize in companies that are not large enough to access public equity markets. Financial engineering refers to the addition of debt or restructuring of existing debt (dividend recapitalizations-a special dividend that is financed with debt)
</aside>
</section>
<section>
<h2>Compensation Structure</h2>
<ul>
<li>"2 & 20"</li>
<ul>
<li>Management fee of 1.5-2.5%</li>
<li>Incentive fee of ~20%</li>
</ul>
<li>Claw-back provision</li>
</ul>
<aside class="notes">
Management fee is based on the capital commitment while the incentive fee is applied to profits exceeding a specified hurdle rate. A claw-back requires that any carried interest be returned at the end of a fund's life if investors have not received a return equal or greater than the hurdle rate.
</aside>
</section>
<section>
<h2>Investment Characteristics</h2>
<ul>
<li>Highly illiquid</li>
<li>Long-term capital commitment</li>
<li>High risk</li>
<li>High expected IRR</li>
<li>High leverage (buyout funds)</li>
<li>Limited information (venture capital)</li>
</ul>
<aside class="notes">
High risk in comparison to seasoned public equity. Limited info: new product/technology/market.
</aside>
</section>
</section>
<section>
<section>
<h2>Real Estate</h2>
</section>
<section>
<h2>Introduction</h2>
<p><em>Real property consisting of the land and buildings on it, along with its natural resources</em></p>
<ul>
<li>Direct ownership</li>
<li>Indirect investment</li>
<ul>
<li>Development/management companies</li>
<li>Real estate investment trusts (REITs)</li>
<li>Commingled real estate funds (CREFs)</li>
<li>Separately managed accounts</li>
<li>Infrastructure funds</li>
</ul>
</ul>
<aside class="notes">
Direct investment via investment in residences, commercial structures, or agriculture. 1. Homebuilders 2. Publicly traded equities that represent pooled capital invested in properties or debt 3. Professionally managed vehicles for investment in RE 4. Make private investment in public infrastructure projects (ie. roads, hospitals, airports) in exchagne for a claim on specified revenue streams over an agreed upon time period
</aside>
</section>
<section>
<h2>Direct Investment Characteristics</h2>
<ul>
<li>Advantages</li>
<ul>
<li>Tax subsidized</li>
<li>Highly leverageable</li>
<li>Direct control</li>
<li>Low correlation between geographies</li>
<li>Low volatility</li>
</ul>
<li>Disadvantages</li>
<ul>
<li>Relatively illiquid</li>
<li>Large lot sizes</li>
<li>Relatively high transaction costs</li>
<li>High due diligence costs</li>
<li>Substantial investor involvement</li>
</ul>
</ul>
<aside class="notes">
1. Unlike several other alternative investments, such as HF or buyout funds, RE is an asset with intrinsic value, not simply an investment strategy. 2. Mortgage interest, property taxes, etc. may be tax deductible
</aside>
</section>
<section>
<h2>Indices</h2>
<p>Smoothed vs. unsmoothed</p>
<aside class="notes">
Property appraisals are used to determine asset values in the NCREIF index. Because of the infrequent nature of these appraisals, prices appear to exhibit considerably lower volatility than in reality. To correct for this bias several methods are used to construct "unsmoothed" indices that provide a more accurate picture of volatility.
</section>
</section>
<section>
<section>
<h2>Commodities</h2>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: A tangible asset that is relatively homogeneous in nature</em></p>
<ul>
<li>Standardized contracts traded among commodity-linked businesses, individuals, and commodity trading advisors(CTAs)</li>
<li>Direct investment (e.g. spot and derivative markets) vs. indirect investments (e.g. commodity-linked equities)</li>
</ul>
<aside class="notes">
Commodities are relatively homogeneous tangible assets. They are typically traded as standardized contracts with the most active participants being commodity-linked businesses, individuals, and commodity trading advisors. There are two primary ways to invest in commodities, the first being direct investment, which is done in the spot and derivative markets through forwards, futures, and options. The second is via indirect investment in the equity of commodity-linked businesses such as mining companies, energy companies, and agricultural companies.
</aside>
</section>
<section>
<h2>Commodity Index Returns</h2>
<ul>
<li>Spot return (price return)</li>
<ul>
<li>Cost-of-carry model</li>
</ul>
<li>Collateral return</li>
<li>Roll return</li>
<ul>
<li>Backwardation (downward-sloping term structure)</li>
<li>Contango (upward-sloping term structure)</li>
</ul>
</ul>
<aside class="notes">
The total return of a commodity can be segmented into 3 major components: the spot return, the collateral return, and the roll return. The spot return is simply the change in the futures price that is caused by changes in the spot price of the underlying commodity and we typically determine this using the cost-of-carry model. The collateral return is a bit less obvious... it's the implied yield generated under the assumption that the investor posts full margin on the underlying and invests that margin in t-bills, so it should be equal to the risk-free rate. Finally, the roll return is the return generated by rolling forward a long futures position. There are two important cases to consider when examining the roll return. The first is backwardation, which refers to a downward-sloping term structure. Under backwardation, the roll return should be positive. The second is contango, which refers to an updward-sloping term structure and a negative roll return.
</aside>
</section>
<section>
<h2>Illustrative Roll Return</h2>
<p>Backwardation</p>
<img src="images/31/backwardation.png" alt="Backwardation">
<aside class="notes">
Let's examine that a bit more closely... Under backwardation, as the futures contract gets closer to maturity, its price should converge to the higher spot price giving us a positive return. And we can confirm that by looking at our table here. We have 3 futures contracts with differing maturities. One expiring in June, one in September, and one in December. If we look at the second column we can see the futures price of each contract in May and the third column shows us the futures price in April. Now, the difference in the two obviously tells us how much the price has changed that month and in the third column we have the price that attributable to changes in the spot price. Finally, if we back out that spot price contribution we are left with the roll return. We can easily confirm this by looking at the June contract: we have 41.73 in May, less 39.54 in April, less .45 which gives us 1.74.
</aside>
</section>
<section>
<h2>Illustrative Roll Return (cont'd)</h2>
<p>Contango</p>
<img src="images/31/contango.png" alt="Contango">
<aside class="notes">
This is a reproduction of the previous exercise but under contango. If we look at the last column, we can see the roll return is negative. This should be intuitive because as the futures contract gets closer to maturity, its price converges to the lower spot price.
</aside>
</section>
<section>
<h2>Investment Characteristics</h2>
<ul>
<li>Business cycle related supply and demand</li>
<ul>
<li>Sensitive to short-term expectations</li>
</ul>
<li>Convenience yield</li>
<li>"Natural" source of return over the long-run</li>
<li>Hedge against unexpected inflation</li>
<li>Diversification benefits</li>
</ul>
<aside class="notes">
First, the supply and demand of commodities is closely linked to the business cycle and tends to be a bit more sensitive to short-term expectations that are stocks or bonds. This should be fairly intuitive... if you think about a scenario where there's been a sharp uptick in economic activity, demand for things like oil or manufacturing inputs will see a sharp increase. Something that's a bit unique to commodities is what we'll call the convenience yield. Think of this as the benefit an investor receives from holding an asset. For example, a manufacturing firm may hold certain raw inputs to protect against a disruption in supply or a sudden increase in demand. Commodities are also viewed as a natural source of return in the long-run given their close linkage to economic fundamentals. Certain commodities, specifically ones that can be stored and that are directly related to economic activity can be an effective hedge against unexpected inflation. Finally, given their low correlation with traditional asset classes, commodities can offer significant diversification benefits
</aside>
</section>
</section>
<section>
<section>
<h2>Hedge Funds</h2>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: A private, actively managed pooled investment vehicle</em></p>
<ul>
<li>Loosely regulated</li>
<li>Flexible investment styles</li>
<li>Aggressive use of leverage</li>
<li>Ability to go long or short</li>
<li>"Absolute return" orientation</li>
</ul>
</section>
<section>
<h2>Types of Hedge Funds</h2>
<p>Many different ways to classify a hedge fund strategy!</p>
<ul>
<li>Equity market neutral</li>
<li>Convertible arbitrage</li>
<li>Fixed-income arbitrage</li>
<li>Distressed securities</li>
<li>Long/short (hedged) equity</li>
<li>Global macro</li>
<li>Fund of funds (FoF)</li>
<li>Emerging markets</li>
</ul>
</section>
<section>
<h2>Fee Structure & Investment Terms</h2>
<ul>
<li>"2 & 20"</li>
<ul>
<li>Management fee of 1-2%</li>
<li>Incentive fee of ~ 20%</li>
</ul>
<li>Lock-up period of ~1-3 years</li>
</ul>
<aside class="notes">
Hedge fund fee structures are commonly referred to as '2&20' or '2 plus 20'. A high-water mark is the specified NAV level, below which incentive fees are not paid. Some funds also have a hurdle rate, which is a specified minimum rate of return that must be achieved before a performance fee is earned. Lock-ups are designed to protect the manager from investor withdrawals resulting in a forced unwinding of positions in an unfavorable market.
</aside>
</section>
<section>
<h2>Index Issues/Biases</h2>
<ul>
<li>Self-selection</li>
<li>Lack of performance persistence</li>
<li>Survivorship bias</li>
<li>Stale price bias</li>
<li>Backfill bias/inclusion bias</li>
<li>Value-weighted indices</li>
</ul>
<aside class="notes">
Self-selection bias is a problem because hedge fund managers are able to choose whether or not to report to a given index. Survivorship bias occurs when managers wiht poor track records close their business and are dropped from the database while high-performers remain which results in a positively biased average return that isn't reflective of actual results. Stal price bias can occur in markets with low liquidity or low trading volume, resulting in measured correlations and volatity being out of line with expectations. Backfill bias is similar to self-selection bias. It occurs when a hedge fund joins an index and is given the option of reporting its past return data for inclusion in the database. Presumably, only managers with high historical returns would choose to do so. Value-weighted indices can mimic the return characteristics of their best-performing constituents over time, as those high-performers' assets appreciate and take up a larger portion of the index.
</aside>
</section>
<section>
<h2>Investement Characteristics</h2>
<ul>
<li>Sill-base/alpha investment strategies</li>
<li>Success may depend on supply of market opportunities</li>
</ul>
<aside class="notes">
Often considered 'skill-based' or alpha investment strategies that are uncorrelated with traditional assets. Thus, manager selection and proper due diligence is key. Fund of funds claim a competitive advantage in manager selection and due diligence. A given strategy's success may depend on the supply of opportunities in the market. For example, a merger arbitrage fund needs a sufficient level of M&A activity and a convertible arbitrage fund requires companies to issue convertible securities.
</aside>
</section>
<section>
<h2>Other Considerations</h2>
<ul>
<li>Incentive fees and lock-up impacts</li>
<li>Fund of funds</li>
<li>Fund size</li>
<li>Vintage effects</li>
<li>Due diligence</li>
</ul>
<aside class="notes">
1. Severe drawdown events may encourage a manger to shutdown if there is a high water mark. Less frequent exit windows may protect a manager from the forced unwinding of unfavorable positions. 2. Reported returns may offer a more accurate view of HF performance because survivorship bias is mitigated (dissolved HF returns are included in the FoF's returns). 3. Smaller funds tend to outperform their larger counterparts, although this is more of a guideline than a hard and fast rule (Bridgewater being an obvious counterexample). 4. It's important to compare a fund's performance with that of other fund's originating in the same year as timing issues can confound comparisons between funds with different vintage years. 5. While due diligence is important for every investment, it's particularly relevant in selecting a HF manager due to the opacity of a HF's current holdings and the lack of disclosure making risk management considerations at the portfolio level difficult.
</aside>
</section>
<section>
<h2>Performance Evaluation</h2>
<ul>
<li>Downside deviation formula</li>
<li>Maximum drawdown</li>
<li>Sharpe ratio formula</li>
<ul>
<li>Time dependent</li>
<li>Not appropriate for asymettrical return distributions</li>
<li>Biaased upwards by illiquid holdings</li>
<li>Doesn't account for correlations with the rest of an investor's portfolio</li>
<li>Not a reliable predictor of future success</li>
<li>Open to manipulation</li>
</ul>
</ul>
<aside class="notes">
The Sharpe ratio measures the average amount of return in excess of the risk-free rate per nit of standard deviation of return. The annual sharpe ratio equals the monthly sharpe ratio multiplied by the square root of 12.
</aside>
</section>
<section>
<h2>Performance Evaluation (cont'd)</h2>
<ul>
<li>Sortino ratio</li>
<li>Gain-to-loss ration</li>
<li>Rolling returns</li>
</ul>
<aside class="notes">
The Sortino ratio is equivalent to the Sharpe ratio except that the denominator is replaced with downside deviation. The gain-to-loss ratio = (number of months with a positive return divided by the number of months with a negative return) * (average up-month return/average down-month return). Simply, it is the ratio of positive return to negative returns over the given time period (the higher the absolute value, the better). Rolling returns provide insight into the consistency of any possible cyclicality of investment returns
</aside>
</section>
<section>
<h2>Sharpe Ratio Manipulation</h2>
<ol>
<li>Lengthening the measurement interval</li>
<li>Compounding monthly returns but no the standard deviation</li>
<li>Writing out-of-the-money puts and calls</li>
<li>Smoothing returns</li>
<li>Removing extreme returns</li>
</ol>
<aside class="notes">
1) Volatility is generally lower over a longer period of time. 3) Increases return via premiums but exposes portfolio to negative skew 4) Illiquid assets and certain derivatives may need to be valued using highly-subject/input sensitive models. These models are open to manipulation/bias. 5) For example, a portfolio manager may enter a total-return swap to pay a fixed cash flow in exchange for receiving the best and worst return over a given time period.
</aside>
</section>
<!--<section>
<h2>Illustrative Sortino Ratio Calculation</h2>
</section>-->
</section>
<section>
<section>
<h2>Managed Futures</h2>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: Private pooled investment vehicles that invest in cash, spot, and derivative markets and employ leverage in a variety of trading strategies</em></p>
<ul>
<li>Similar to hedge funds</li>
<li>Use derivates in pursuit of return in macro equity and fixed income markets</li>
</ul>
<aside class="notes">
Most of what we discussed in the hedge fund presentation also applies to managed futures. Managed futures are often categorized as a subset of Global Macro hedge funds
</aside>
</section>
<section>
<h2>Trading Styles</h2>
<ul>
<li>Trading strategies</li>
<ul>
<li>Systematic</li>
<li>Discretionary</li>
</ul>
<li>Market focus</li>
<ul>
<li>Financial</li>
<li>Currency</li>
<li>Diversified</li>
</ul>
</ul>
<aside class="notes">
Systematic trading strategies are rule-based trading models (i.e. trend-following, contrarian). Discretionary trading strategies incorporate the portfolio manager's judgment.
</aside>
</section>
<section>
<h2>Investment Characteristics</h2>
<ul>
<li>Zero sum</li>
<li>Returns independent of overall market movements<!--[explain 2 sources of return (risk premium and differential carrying costs)]--></li>
<li>Evidence of performance persistence</li>
<li>Relative riskiness/beta is a good predictor of future performance</li>
</ul>
<aside class="notes">
Managed futures are "zero sum": derivatives markets reallocate uncertain cash flows among market participants without affecting aggregate cash flows. As a result, the long-term return to passively managed, unlevered futures positions should be the risk-free reate less management fees and transaction costs. However, if there is a sufficient number of hedgers who systematically earn less than the risk-free rate, positive excess returns may be possible.
</aside>
</section>
</section>
<section>
<section>
<h2>Distressed Securities</h2>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: The securities of companies that are in financial distress or near bankruptcy</em></p>
<ul>
<li>Constraints on sub-investment grade holdings</li>
<li>Sparse coverage by research analysts</li>
<li>Legal complexity</li>
</ul>
<aside class="notes">
Investors aim to exploint inefficiencies due to many investors being unable to hoold sub-IGD due to regulatory or policy constraints. Fallen angels refer to formerly IGD that has deteriorated into high yield and may no longer be held by some investors. Additionally, the potential bankruptcy process and related negotiations can be very complex from a legal standpoints.
</aside>
</section>
<section>
<h2>Investment Types</h2>
<ul>
<li>Hedge fund vs. private equity structures</li>
<li>Asset selection</li>
<ul>
<li>Publicly traded debt and equity</li>
<li>Orphan equity</li>
<li>Bank debt and trade claims</li>
<li>"Lender of last resort" notes</li>
<li>Variety of derivative instruments</li>
</ul>
</ul>
<aside class="notes">
Hedge fund structures offer the ability to accept new capital on a continuous basis and tends to be more lucrative from the manager's standpoint. Private equity structures have a fixed term and do not accept new capital once the offering period expires. Orphan equity is newly issued equity of a company emerging form reorganization. Derivatives are primarily used for heding purposes
</aside>
</section>
<section>
<h2>Investment Strategies</h2>
<p>Requires specialist expertise in credit analysis, turnarounds, business valuation, and bankruptcy proceedings</p>
<ul>
<li>Long-only value investing</li>
<li>Distressed debt arbitrage</li>
<li>Private equity</li>
</ul>
<aside class="notes">
Long-only consists of investing in high-yield debt or orphan equities. Distressed debt arbitrage refers to the purchase of the debt of troubled companies while simultaneously shorting the company's equity. "Active" private equity investors become major creditors in an effort to exert influence over bankruptcy proceedings. Prepackaged bankruptcies occur when a debtor seeks agreeement from creditors on terms of a reorganization prior to filing Chapter 11. These types of investors are often derided as "vulture investors".
</aside>
</section>
<section>
<h2>Investment Considerations</h2>
<ul>
<li>Event risk</li>
<li>Market liquidity risk</li>
<li>Market risk</li>
<li>J factor risk</li>
</ul>
<aside class="notes">
Event risk is company or situation-specific risk. Market liquidity risk is high due to the highly cyclical nature of distressed investing: distressed securities are naturally less liquid than their non-distressed counterparts. Market risk refers to risk arising from the economy, interest rates, and equity markets. J factor risk refers to the uncertainty of a judge's involvement in bankruptcy proceedings. It's important to consider a judge's track record and preferences shown in prior proceedings.
</aside>
</section>
<section>
<h2>Other Consideration</h2>
<ul>
<li>Non-normal return distribution</li>
</ul>
<aside class="notes">
Because of the negative skewness and positive kurtosis of distressed investing a normal return distribution is not appropriate, thus rendering the Sharpe ratio inaccurate as a measure of true risk
</aside>
</section>
<section>
<h2>Bankruptcy Process</h2>
<ul>
<li>Chapter 7 vs. Chapter 11</li>
<li>Debtor-in-possesion</li>
<li>Voluntary vs. involuntary</li>
<li>Pre-packaged filing</li>
<li>Exclusivity period</li>
<li>Cram-down</li>
<li>Absolute priority rule</li>
</ul>
<aside class="notes">
Under Chapter 7, a firm's assets are collected and liquidated and it ceases to exist. Under Chapter 11, the debtor is provided an opportunity to reorganize/restructure and continue as a going-concern. When under Chapter 11 protection, a firm is referred to as a debtor-in-possession, during which time it will seek to pay off creditors according to a plan approved by the court without the threat of having its assets seized by creditors. A bankruptcy proceeding can be initiated by the firm itself (voluntary) or by involuntarily by its creditors. In the case of voluntary filings, the company will often work with creditors in advance to establish an agreed-upon reorganization plan to minimize costs and time spent in bankruptcy. Upon filing for Chapter 11, the company enters an exclusivity period during which it has the sole ability to submit a plan. Once this period expires, any party with an interest in the bankruptcy can file an alternative plan. Creditors and equity-holders must then agree to the plan. If they are unable to do so, the judge may, in some cases, overrule any dissenters (the "impaired class") and "cram-down" the plan. The absolute priority rule states that any reorganization plan must respect the rule of priority with regard to the order of claims by security holders (senior secured before bonds before shareholders, etc.).
</aside>
</section>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
</section>
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