Alternative Investments Uses and Features
Used for: diversification and potential for active management
Features
- Low liquidity
- good diversification
- high due diligence costs
- difficult to value
- Informationally inefficient (requires special skills)
Role of different AI in the Portfolio
Unique Risk Factors
Real estate and commodities
Unique Investment Strategies requiring manager skill
Hedge Funds and Mangaged Futures
Blend of Above
Private Equity and distressed equities
Due Diligence Checkpoints
Assess the following;
- Market opportunity
- Investment process
- Service providers (brokers, lawyers, etc.)
- Terms/structure of investment
- Organization and People
- Review & document
Special Issues for Private Clients
- Tax considerations
- Suitability
- Communication (client’s level of knowledge)
- Do they understand the risk?
Real Estate Types
Types
Direct “equity”: residential, commerical, etc - direct management
Benchmark: NCREIF - quarterly, value-weighted (unlevered)
Indirect: REITS, CREFs (commingled), SMAs, other real estate companies
Benchmark: NAREIT - cap-weighted REITs, investable (levered)
Direct RE Pros/Cons
ProsCons
- tax-deductible expenses High commission/transaction costs
- allows high leverage Each propery is unique
- direct control High unit costs
- low return volatility Hands on management
Real Estate Characteristics
- Interest rates ^, RE down
- correlation with population
- Inflation hedge
CREFs, much better reflection of true RE performance
Smoothing
- Appraisals rely on past data and understate swings in value
- Appearance of stability: periodic appraisals instead of continuous pricing
RE Benchmarks
NCREIF IndexNAREIT Index (REIT)
- Quarterly reported All REITS on NYSE
- Value-weighted Cap-weighted
- Annual appraisals Blend of RE and equity
- Smoothing (understates volatility) “Hedged” strips out equity charact.
- Not investable Investable
Private Equity Types
Types
- Venture capital - investing in private firms (J curve)
- High failure rate
- Less cash flows
- Not leveraged
- Buyout funds - buy public firm and take private
- Earlier and steady cash flows
- Less error in measuring returns
- Less upside potential
PE Traits
- High failure rate
- Structure/price negotiated
- Internal (nonpublic) information may be used
- Involves active role is managing business
PE Vocabulary
- Seed: for market research/ R&D
- Start-up: pre-revenue to bring idea to life
- Mezzanine: funding to IPO
- Angel Investor: first investors
- VC: specialist providing financing and expertise
Private Equity
Direct vs Indirect Investing
- Direct
- Convertible Preferred Stock
- First claim on cash flow and assets
- Convertible Preferred Stock
- Indirect
- Through LPs or LLCs
- Provides tax advantages (avoids double tax)
- GP - selects and manages, plans exit
- Through LPs or LLCs
Private Equity
Fee Structures
- Annual base fee: 1.5-2.5%
- Carried interest fee: incentive fee after investors capital returned
- Performance fee: % of profits above hurdle rate or preferred return
- Claw-black: reclaim fees if fund doesn’t meet minimum return
Private Equity
Issues
- High risk and return
- Illiquid
- Long time horizon, 7+ years
- Limited information
- Lack of marketability and control may lower valuations
Commodities
Direct vs Indirect Investment
Storable vs Nonstorable
Direct Indirect
Cash purchase Buy companies (mining company)
Long derivatives Mutual Fund/ETFs
Storable Nonstorable
Metal, gold, energy Agriculture
Inflation hedge No inflation hedge
Commodities
Benchmarks
Weighting Typpes
- Based on long only futures contract prices (Dow Jones)
- Replicable and Investable
Two weighting types:
Worldwide production
Perceived worldwide importance
Commodities
Return Sources
Formula: Total return = collateral return + spot return + roll return
- Collateral Yield: known in advance
- Spot Return: ▲ in futures price (Ft - F0)
- Roll Yield
- (Ft - F0) - (St - S0)
- Backwardation: F0 < S0 positive roll
- Contango: F0 > S0 negative roll
Example: Futures price changed by $6, the spot return is $2, collateral return is $1.
Roll return = 6 - 2 = 4, Total return = 1 + 2 + 4 = 7
Managed Futures Traits
Skilled based investment
Uses derivatives markets (futures/options) going long/short
Hedge Funds
Issues and Concerns
- investment characteristics change over time
- survivorship and backfill bias
- due diligence issues (many are unregulated)
- Understated std (risk) and correlation
- Overstated Sharpe ratio
- Infrequency pricing leads to smoothing
Fund of Funds Pros and Cons
ProsCons
- Shortened due diligence process Double management fees
- Can replicate a HF index Higher change of style drift
- Diversification
