Chapter 11

Question 1

An investment is generally considered alternative if it meets what 6 criteria?

Answer 1

1. Has different performance characteristics from traditional assets (non normal distribution)
2. Rarely traded
3. Relatively illiquid
4. Relatively uncommon in portfolios
5. Has a relatively limited investment history
6. Requires unconventional investment skills on the part of an investment manager

Question 2

What are the four major categories of alternative investments?

Answer 2

1. hedge funds
2. private equity
3. real estate
4. commodities

Question 3

Define and describe hedge funds

Answer 3

• lightly regulated pools of capital whose managers have great flexibility in their investment strategies
• no restrictions on short positions, use derivatives for leverage and speculation performance arbitrage transactions, and invest in any situation where they see an opportunity

Question 4

What are three characteristics that mutual funds and hedge funds share?

Answer 4

1. they are pooled investments that may have front end or back end sales commissions
2. they charge mgmt fees
3. they can be bought and sold through an investment dealer

Question 5

What are the three major categories of of HF strategies?

Answer 5

1. Relative value strategies
2. Event driven strategies
3. Directional strategies

Question 6

Describe relative value strategies

Answer 6

• attempt to profit by exploiting inefficiencies or arbitrage opportunities in the pricing of related stocks, bonds etc.
• HFs using these strategies generally have low or no exposure to the underlying market direction

Question 7

Describe event drive strategies

Answer 7

• seek to profit from unique events such as mergers and acquisitions
• HFs using these have medium exposure to the underlying market direction

Question 8

Describe directional strategies

Answer 8

• bet on the anticipated movements in the market price of equity securities, debit securities, foreign currencies, and commodities
• HFs using these have high exposure to trends in the underlying market

Question 9

What are the types of relative value strategies?

Answer 9

• equity market neutral (simultaneous long and short)
• convertible arbitrage
• fixed income arbitrage

Question 10

What are the types of event driven strategies?

Answer 10

• merger or risk arbitrage
• distressed securities
• high yield bonds

Question 11

What are the types of directional strategies?

Answer 11

• long/short equity (most popular HF strategy) (buy more of what they like and short what they don’t)
• global macro
• emerging markets
• dedicated short bias

Question 12

What are FoFH and what are the two main types?

Answer 12

• fund of HFs (FoHF) is portfolio of HFs overseen by a manager who determines which HFs to invest and how much to invest in each
• the two main types are single-strategy and multi-strategy

Question 13

What are the main advantages of FoHFs?

Answer 13

• due diligence
• reduced volatility (diversification)
• professional management
• access of HFs
• ability to diversify with a smaller investment
• manager and business control risk (“blow up risk”)

Question 14

What are the main disadvantages of FoHFs?

Answer 14

• additional costs
• no guarantee of positive returns
• low or no strategy diversification
• insufficient or excess diversification
• additional sources of leverage

Question 15

How does one invest in commodities?

Answer 15

Directly or indirectly (through derivatives)

Question 16

What are managed futures funds?

Answer 16

• funds that invest in listed financial and commodity futures markets and currency markets around the world
• fund managers = commodity trading advisors (CTAs)

Question 17

What is mezzanine capital?

Answer 17

• financing by floating high yield unsecured preferred equity or subordinated loans
• ranks just above common stock in seniority but is a comparatively cost effective way for firms to raise capita l

Question 18

What are six key facts about private equity?

Answer 18

1. Shares are illiquid with no resale value
2. Long maturity
3. High risk-return profile
4. Proven that long term returns are higher than traditional equity (but with higher volatility)
5. Often investment is by invitation only
6. Usually fits in a portfolio as an equity substitute

Question 19

What are 9 distinguishing features of real estate as an investment?

Answer 19

1. People feel more comfortable leveraging it
2. Costs are high
3. There are added due diligence, maintenance, and repair costs
4. Tax liabilities can be significant
5. Real estate my represent a significant portion of net worth
6. Real estate market returns compete with other asset market returns
7. Positively correlated with inflation
8. Long holding periods
9. Considered to be a bond substitute

Question 20

What are 4 main features of REITs?

Answer 20

1. Publicly traded (liquid, accessable)
2. High and stable average rate of return
3. Tax efficient
4. Correlated to equities but can also be a high yield bond substitute

Question 21

What was the catalyst for people to start investing in alternative investments more often?

Answer 21

-the sharp technology-led sell off in the global equity markets in 2000 coupled with low yields available encouraged investors to shift a portion of their investments in traditional asset classes into different forms of alternative investments

Question 22

What are the 9 potential benefits of alternative investments?

Answer 22

1. Improved diversification
2. They can realize profit in any economic environment
3. Reduce portfolio volatility
4. Enhance long-term total risk-adjusted returns
5. Investors gain access to investment managers that are not generally available to the public
6. Preserve capital in volatile markets
7. Provide access to global markets
8. Align with investors interests through variable performance fees
9. Align the interests of investors with those of the investment managers

Question 23

Describe the relationship between MPT/mean-variance optimization and alternative investments

Answer 23

• MPT contends that a portfolio’s diversification across different asset classes with low or negative correlation characteristics will minimize risk
• these types of asset allocation models make strong assumptions about market structure, statistical pricing dynamics, investor behaviour etc.
• alternative investments do not conform well to many of the key assumptions underlying standard mean-variance optimization

Question 24

Security pricing for unlisted and non-marketable securities and assets is often a mix of _______ and _______ and sometimes the _____ component can lead to serious issues for a fund and its investors.

Answer 24

• art and science

- art

Question 25

What are the elements of performance attribution that are difficult with alternative investments?

Answer 25

- lack of suitable benchmarks - lack of mandate definition and standardization - lack of investment strategy transparency

Question 26

What are the 13 unique risks of alternative investments?

Answer 26

1. Less regulatory oversight 2. Transparency risk 3. Manager and market risk 4. Complexity of investment strategies 5. Liquidity risk 6. Product liquidity constraints (lock up periods and liquidity dates) 7. Limitations on transferability 8. Income tax implications 9. Pricing risk 10. Short squeeze risk 11. Counterparty risk 12. Financing risk 13. Business risk

Question 27

Define due dilligence

Answer 27

- a reasonable investigation of a proposed investment and its principals - the goal of due diligence is to ascertain an investment's worthiness and appropriateness for particular types of investors - the primary objectives are to properly determine the risk and profile of an investment and to address as many of the risks as possible

Question 28

When investing in any type of investment fund, whether it involves traditional or alternative investments, the investor is buying into four main factors:

Answer 28

1. The expertise and capabilities of the investment managers principal officers 2. The investment manager's specific investment strategies, processes, and systems 3. The fund's historic performance 4. The fund's corporate tax, regulatory, and custodial structure

Question 29

What are the four stages of due diligence?

Answer 29

1. Screening potential investments 2. Identifying potential investment opportunities through performance reviews and presentations from investment managers 3. Conducting full due diligence reviews and analysis 4. Continuously monitoring the fund and its investment manager after the investment has been made

Question 30

A comprehensive due diligence process of investment funds should address what 8 main areas?

Answer 30

1. Structure of the investment management organization 2. Investment management information 3. Fund or product risk analysis 4. Operations and an assessment of operational risks 5. Fund or product structure 6. Investment performance and attribution analysis 7. Investment manager's account structure and composition 8. Compensation and fee structure

Question 31

What are the key areas of assessing an alternative investment fund's risk profile?

Answer 31

1. Investment manager's investment process and strategy 2. Fund details 3. Investors legal and taxation issues 4. Business issues 5. Hypothetical questions

Question 32

What are three major trends and developments in alternative investments?

Answer 32

1. Increased government regulation 2. Institutionalization 3. Continued innovation