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101 Concepts for the Level I Exam

Concept 96: Types of Alternative Investments


Hedge funds

  • Uses a partnership structure with a general partner who manages the fund and accepts unlimited liability and limited partners (investors) who own fractional interests in the partnership and have limited liability.
  • The general partner typically receives a management fee based on assets under management and an incentive fee based on the performance of the fund.
  • Hedge funds are typically classified by strategy into four broad categories:
    • Event-driven: Includes merger arbitrage, distressed/restructuring, activist shareholder and special situation.
    • Relative value: Strategies that seek to profit from pricing discrepancies.
    • Macro: Strategies based on top-down analysis of global economic trends.
    • Equity hedge: Strategies based on bottom-up analysis. Includes market neutral, fundamental growth, fundamental value, quantitative directional, and short bias.
  • During financial crisis the correlation of returns between global equities and hedge funds tends to increase, which reduces the hedge funds’ usefulness as a diversifying asset class.

Private equity

  • Uses a partnership structure with a general partner who manages the fund and accepts unlimited liability and limited partners (investors) who own fractional interests in the partnership and have limited liability
  • The general partner typically receives a management fee based on committed capital and an incentive fee based on the performance of the fund.
  • Dominant strategies in private equity funds are leveraged buyouts and venture capital. Other strategies include development capital and distressed investing.
  • Types of LBOs include
    • Management buyouts: The existing management team is involved in the purchase.
    • Management buy-ins: External management team replaces the current management.
  • Stages in venture capital include
    • Formative stage: Consists of angel investing, seed and early stages.
    • Later stage: Company is in expansion phase.
    • Mezzanine stage: Company is preparing for an IPO.
  • Exit strategies for investments in portfolio companies include
    • Trade sale: Company is sold to a competitor or another strategic buyer.
    • IPO: Company is sold to the public.
    • Recapitalization: Company is re-leveraged when interest rates are low.
    • Secondary sale: Company is sold to another private equity firm or another investor.
    • Write off/ liquidation: Assets are sold and liabilities are settled.
  • Historically, private equity has provided potential diversification benefits. However, an investor must identify top performing private equity managers to benefit from private equity.

Real estate

  • Primary reasons to invest in real estate include:
    • Potential for competitive long term returns
    • Rental income
    • Diversification benefits
    • Inflation hedge
  • Investment characteristics of real estate include:
    • Indivisibility
    • Unique characteristics(no two properties are identical)
    • Fixed location
    • Operational management
    • Local markets can be very different from national or global markets
  • Basic forms of real estate investments are shown in the following table:
  Debt Equity
Private Mortgages

Construction lending

Direct ownership of real estate

Ownership can be through sole ownership, joint ventures, real estate limited partnerships etc.

Public Mortgage-backed securities (residential and commercial)

Collateralized mortgage obligations

Shares in real estate corporations

Shares of real estate investment trusts (REITs)

  • Historically, real estate returns are highly correlated with global equity returns but less correlated with global bond returns.

Commodities

  • Commodity investments can be achieved by investing in actual physical commodities or in companies that produce commodities. However, usually commodity investing is achieved using commodity derivatives.
  • The return on a commodity investment includes:
    • Collateral yield: Return on collateral posted to satisfy margin requirements.
    • Price return: The gain or loss due to changes in the spot price.
    • Roll yield: Gain or loss resulting from re-establishing future positions. Roll yield is positive if futures market is in backwardation and negative if the market is in contango.
  • Commodities are viewed as a good inflation hedge. They also have a low correlation with traditional investments and can provide diversification benefits.

Infrastructure

  • Infrastructure assets are real assets that are planned for public use and to provide essential services. They are typically capital intensive and long-lived.
  • These assets are expected to generate stable cash flows that should adjust for economic growth and inflation. They may also provide capital appreciation.