IFT Notes for Level I CFA^® Program

R50 Introduction to Alternative Investments

Part 1

1. Introduction

This reading will cover the basic categories and characteristics of alternative investments and how to value hedge funds, private equity, real estate, and commodities. We will also briefly look at the role they play in diversifying a portfolio.

2. Alternative Investments

Traditional investments: Long-only positions in stocks, bonds, and cash.

Alternative investments: All other investments including real estate, commodities, hedge funds, private equity funds, etc.

The general characteristics of alternative investments are listed below:

High fees because of active management and expertise required in managing the portfolio.
Low diversification within the alternative investment portfolio because the required investment amount is typically high.
High use of leverage
Narrow manager specialization: For example, within private equity, you have leveraged buyout and venture capital. There are managers who focus only on leveraged buyouts within private equity.
Relatively low correlation with traditional investments; may be correlated during times of financial crisis.
High fees
Concentrated portfolios
Restrictions on redemptions (i.e., “lockups” and “gates”)
Low level of regulation and less transparency.
Limited and potentially problematic risk and return data: The risk and return data of hedge fund and private equity indices are biased, as we will see later.
Unique legal and tax considerations.

2.1. Categories of Alternative Investments

The main categories of alternative investments are:

Hedge funds

They are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies.
They aim for absolute returns independent of market performance.

Private equity

Investment in private equity can be made either via direct investment (including co-investment) or indirectly via private equity funds.
Private equity funds invest in the equity of private companies or public companies that want to become private.
They are further divided into
- Leveraged buyout funds: Invest in established companies.
- Venture capital funds: Invest in startup.

Real estate

Investments in buildings, farmland, timberland, either directly or indirectly.

Commodities

Investment in physical assets such as grains, metals, crude oil, etc.
The main vehicles used for investment in commodities are commodity future contracts and funds benchmarked to commodity indices.

Infrastructure

Investments in capital intensive, long-lived, real assets such as roads, dams, and schools, which are intended for public use and provide essential service.
Example of infrastructure investing is a public–private partnership (PPP) approach in which both government and investor have a stake.

Other

Investments in any other tangible asset such as art, wine, stamps, coins, etc.
Or intangible assets such as patents and litigation actions).

2.2. Returns to Alternative Investments

Broadly speaking, there are two strategies for generating returns: passive and active.

Passive investments focus on index or asset class coverage. Example: If a manager invests the entire amount in an ETF tracking the S&P 500, like Vanguard S&P 500 ETF, then he is a passive manager.
Generally, alternative investments are actively managed.

Investors typically prefer alternative investments for diversification purpose and to generate a relatively high expected returns on a risk-adjusted basis. However, alternative investments are subject to non-typical risks such as: low liquidity, limited redemption availability and challenge of manager diversification etc.

2.3. Portfolio Context: Integration of Alternative Investments with Traditional Investments

What is the motivation for investing in alternative investments? One of the primary drivers is the low correlation of alternative investment with traditional investments. This low correlation along with relatively high returns on some alternative investment categories results in a substantial diversification benefit.

2.4. Investment Structures

The most common structure for many alternative investments is a partnership. It consists of two entities:

General partner (GP): The fund is the general partner (GP). These are the partners responsible for managing the private equity firm and making the investment decisions.
Limited partners (LP): The investors who provide capital are the limited partners. They bear the risk associated with investments and have a fractional partnership in the fund.

3. Hedge Funds

History: Alfred Winslow Jones created a “hedged” fund in 1949. The purpose of this fund was to hedge long-only stock portfolio. The fund followed three key principles:

Always maintain short positions.
Always use leverage.
Only charge an incentive fee of 20% of the profits with no fixed fees.

Over time, the principles have changed. The following are the characteristics of hedge funds today:

Aggressively managed portfolios of investments across asset classes and regions use leverage, take long/short positions, and/or use derivatives.
Generate high returns: either absolute or over a specified benchmark with minimal restrictions.
Set up a private investment partnership with a limited number of investors who are willing to make a large initial investment.
Investors are required to keep the money with the fund for a certain period – lockup period. Redemptions are not immediate. Usually, require a minimum notice period of 30 to 90 days.
Invest anywhere there is a high return opportunity as restrictions are less.

A diversified portfolio of hedge funds is often referred to as a fund of funds. This instrument makes hedge funds accessible to smaller investors or to those who do not have the resources, time, or expertise to choose among hedge fund managers. Other benefits include:

Better redemption terms;
Due diligence expertise;
More diversification as they invest in hedge funds across geographies and strategies

Each hedge fund into which a fund of funds invests has a management fee plus an incentive fee. The fund of funds itself also has a management fee and may also receive an incentive fee.

3.1. Hedge Fund Strategies

There are several hedge fund strategies. These fall in four major categories:

Event-driven: A short term, bottom-up strategy that aims to profit from pricing inefficiencies before a major potential corporate event. Ex: bankruptcy, acquisition, merger, restructuring of a company, asset sale (large pocket of land in a prime location).
Relative value: A strategy that seeks to profit from price discrepancy between related securities such as stocks and bonds.
Macro: Uses a top-down approach to identify trends based on changes in economic policies across the globe. The strategies could focus on currency markets, fixed income markets, or based on changes in interest rates. Trades are based on expected movement in economic variables.
Equity hedge: Bottom-up strategy. Not focused on event-driven or macro strategies. Take long and short positions in equity/equity derivative securities.

The sub-classifications under each category are listed below:

Sub-classification under event-driven category
Merger Arbitrage	Go long (buying) on the stock of the company being acquired and go short on the stock of the acquiring company. Risk: many corporate events such as merger do not occur as planned and if the fund has not closed its positions on time, it may incur losses.
Distressed/restructuring	Purchase and profit from debt securities of companies that are either in bankruptcy or near bankruptcy. Strategy: the fixed income securities would be priced at a significant discount to their par value; these can be sold later at a profit at settlement (liquidation or equity stake) Other complicated strategies: Buy senior debt/short junior debt. Buy preferred stock/short common stock.
Activist	Purchase a managing equity stake in a public company that is believed to be mismanaged, and then influence its policies. May advocate restructure, changes in strategy, hiving off non-profitable units, etc.
Special Situations	Purchase equity of companies engaged in restructuring activities other than merger/bankruptcy.
Sub-classification under relative value category
Fixed-Income Convertible Arbitrage	A market neutral strategy to exploit mispricing in convertible bond and issuer’s stock. Long position in convertible debt + short position in issuer’s common stock. As the name implies, it has a theoretical zero-beta portfolio. Note: A convertible bond is a bond (hybrid security) that can be converted into common stock at a pre-determined price at a pre-determined time. Usually, the yield is lower than a comparable bond.
Fixed-Income Asset Backed	Exploit mispricing of asset-backed securities.
Fixed-Income General	Exploit mispricing between two corporate issuers (i.e. long/short trades), between corporate and government issuers, or between different parts of the same issuer’s capital structure.
Volatility	Go long or short market volatility within a specific asset class.
Multi-Strategy	Generate consistently absolute positive returns irrespective of how the equity, debt, or currency markets are performing. Does not focus on one strategy, but allocates capital across different strategies where investment opportunities exist. Ex: equity long/short, convertible arbitrage, merger arbitrage, etc. Unlike funds of funds, multi-strategy funds execute strategies within one fund group and they do not have the extra layer of fees associated with a fund of funds.
The curriculum does not present any sub-classifications under the macro category.
Sub-classifications under the equity hedge category
Market Neutral	Uses quantitative/fundamental analysis to identify undervalued/overvalued securities. Strategy: buy (long) undervalued securities and sell (short) overvalued securities. Hold equal dollar amounts in both positions. Neutral with respect to market risk, i.e., the portfolio beta is close to zero.
Fundamental Growth	· Uses fundamental analysis to identify companies with high growth potential and capital appreciation. · Strategy: long position in such stocks.
Fundamental Value	Uses fundamental analysis to identify undervalued companies. Strategy: long position in such stocks.
Quantitative Directional	Uses technical analysis to identify overvalued and undervalued companies. Strategy: long position in undervalued securities and short position in overvalued securities. Weight of long and short positions depends on the market cycle.
Short Bias	Uses quantitative/fundamental analysis to identify overvalued securities. Strategy: short position in overvalued securities.
Sector Specific	Uses quantitative/fundamental analysis to identify mispricing in a specific sector. Strategy: long on undervalued securities/short on overvalued securities.

3.2. Hedge Funds and Diversification Benefits

Due to different strategies across hedge funds, the diversification benefits associated with every hedge fund is not necessarily meaningful. It is believed that less-than-perfect correlation of hedge funds with stocks provides diversification benefit. However, for the period since 2000, the low correlation claim holds only for 2000-02; between 2003 and 2009, there was a high correlation between stocks and hedge funds. This implies that during financial crisis periods, the correlation between hedge fund performance and stock market performance may increase. However, the losses for hedge funds may be less than for the equity markets.