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Concepts
Alternative investments

Description
Introduction to Alternative Investments
Investment in assets other than stocks, bonds and cash, including:
- Real estate
- Commodities
- Collectables
- Hedge fund (limited partnership)
- Private equity fund (limited partnership)
- Real estate investment trusts (REITs)
- Exchange Traded Funds (ETFs) that contain alternative investments

Differences between traditional
investments and alternative
investments

Compared to traditional investments, alternative investments have:
- Lower liquidity
- Less regulations and disclosure
- Higher management fees
- More specialised management
- Potential diversification benefits
- More use of leverage and derivatives
- Potential higher return
- Limited and possible biased historical returns data
- Problematic historical risk measures
- Unique legal and tax consideration

Hedge funds - Introduction

Hedge funds are limited partnership of investors with adequate wealth, sufficient liquidity, and acceptable degree of investment sopistication
Return objectives can be statedd on an absolut basis (e
...
: 10%) or relative basis (e
...
: S&P 500 + 5%)
Hedge funds could employ different strategy, including:
- Take short equity positions
- Take long and short positions in derivatives
- Use leverage
Trade through prime brokers, who provide custodial services, administrative services, money lending, securities lending for short sales, and trading
Hedge funds are less liquid than traditional investments, with restrictions:
- Lockup period : period of withdrawal restriction after the initial investment
- Notice period : the amount of time a fund has after receiving a redemption request to fulfill that request
Management fee = % of committed capital
Incentive fee = % of profit
Fund of funds : an investment company that invests in multiple hedge funds → more diversifica on , allow smaller investors to access hedge funds
...
Event driven strategies : based on corporate restructuring or acquisition that creates profit opportunities for long / short positions
- Merger arbitrage : Buy shares of firms being acquired , sell sort the firm making the acquisition
- Distress / Restructuring : Buy undervalued securities of firms in financial distress, when analysis indicates value will be increased by successful restructuring
- Activist shareholder : Buy sufficient equiy shares to influence a company's policy → increasing company value
- Special situations : Invest in firms that are issuing / repurchasing securities , spinning off divisions , selling assets , or distributing capital
2
...
common stock of the issuing companies
- Asset-backed fixed income : Exploit pricing discrepancies between various mortgage-backed securities / asset-backed securities
- General fixed income ; Exploit pricing discrepancies between fixed income securities of various types
- Volatility : Exploit pricing discrepancies aring from differences between return volatility implied by options prices and manager expectations of future volatility
- Multi-strategy : Exploit pricing discrepancies among securities in asset classes different from those listed above
3
...
Equity hedge fund strategies : profit from long/short positions in publicly traded equities and derivatives with equities as underlying assets
- Market neutral : Use techical / fundamental analysis to select undervalued equities for long / overvalued equities for short selling
- Fundamental growth : Use fundamntal analysis to find high-growh companies
- Fundamntal value : Buy shares that are believed to be undervalued based on fundamental analysis
- Quantitative directional : Buy securities believed to be undervalued / Sell short securities believed to be overvalued based on technical analysis
- Short bias : Short position in overvalued equities

Hedge funds - Benefits / Risks

Benefits:
- Offer some diversification
Risks:
- In period of financial crisis, correlation of returns between global equities and hedge funds then to increase → limit hedge funds' effectiveness as a diversifying asset class
- Survivorship bias (excluded the performance of firms that no longer exist)
- Backfill bias (do not report performance at inception, but backfill performance later, when success track record is established)

Hedge funds - Due diligence

- Investment strategy
- Investment process
- Source of competitive advantages
- Historical returns
- Valuation and returns calculation methods
- Longevity
- Amount of assets under management
- Management style
- Key person risk
- Reputation
- Growth plan
- Systems for risk management
- Appropriateness of benchmarks
** Note:
- Lack of persistent in returns : funds with bettr historical returns might not provide better than average returns in the future
- Reputation, risk management systems and management styple : difficult to quantify
- Previous profitable strategies to exploit pricing inefficiencies are likely to become less profitable as more funds pursue the same strategy

Hedge fund - Valuation

Hedge funds values = MV of traded securities in the portfolios
- MV of traded securities : bid prices for long position ; ask prices for short position
- MV of illiquid securities : Quoted market prices might be reduced for the degree of illiqidity
- MV of non-traded securities : use model

Private equity - Strategies

1
...
PE profits from the increase in value of the firm through combination of new management, management incentives, restructuring, cost reduction or revenue enhancement
- Management buyouts : existing management team is involved in the purchase
- Management buy-in : external management team will replace the existing management team
2
...
VC fund managers are closely involved in the
development of portfolio companies (by sitting on the boards; or filling key management roles)
- Formative stage : invest during a firm's earliest period
+ Angel investing : invest in the very early stage of a firm's life (idea stage)
+ Seed stage : invest for product development, marketing and market research
+ Early stage : invest to fund initial commercoal production and sales
- Later stage : Invest in the stage of development, when the company already has production an sales
...
Developmental capital (or minority equity investing) : provision of capital for business growth or restructuring
4
...
Primary methods of exiting:
1
...
IPO
3
...
Secondary saale : sell a portfolio company to another PE / group of investors
5
...
Market / Comparables approach : MV / private transaction value of similar companies are used to determine multiples of EBITDA, net income, or revenue → Calculate the por olio
company's value
2
...
Asset-based approach : Liquidation values / FV of assets

Real estate - Introduction

Generate income from rents and potential capital gains
Categories of Real estate investment
1
...
Commercial real estate
3
...
Mortgage-backed securities
5
...
Farmland

Real estate - Risks and Benefits

Real estate - Due diligence

Benefits:
- Provide diversification benefit
- Rent and real estates values tend to increase with inflation → Provide potential inflation hedge
Risks:
- Strong correlation between REIT index returns and global equity returns (which might caused by the method of index construction (appraisal / repeat sales indices)
- Global and national economic factors
- Local market conditions
- Interest rate levels
- Abilities of managers to select and manage properties
- Changes in regulations
- Degree of leverage used in a real estate
Distressed properties : has additional risk factors compared to properties with sound financials and stable operating history
Real estate development : addtional risk factors, including regulations (zoning, permitting, environmental considerations or remediation), economic changes and financing decisions over
the development period

Real estate - Valuation

1
...
g
...
Capitalisation rate = (discount rate - growth rate)
- Cost approach : Replacement cost of a property
...
Methods to value REITs
- Income based approach : (Cash flow / capitalisation rate)
...
Tailored to the needs of specific investors
- Specialised funds in specific commodity sectors :focus on certain commodities (e
...
: oil, gas, grains, precious metals, etc
...

1
...
Demand:
- Affected by value of commodities to end-users, and by global economic conditions and cycles
- Commodity prices can be volatile when demand changes significantly over the economic cycle
To estimate future needs, investors need to analyse:
- Economic events
- Government policies
- Forecast of future supply
To estimate commodities price, investors need to analyse:
- Inventory levels
- Forecast of production
- Changes in government policies
- Expectations of economic growth

Commodities - price

Commodities - Valuation

Future price ≈ Spot price × (1 + Risk free rate) + Storage costs - Convenience yield
Convernience yield : value of having physical commodity for use over the period of futures contract
Contango : Little to no convenience yield → Future prices > Spot prices
Backwardation : High convenience yield → Future prices < Spot prices
3 sources of commodities future returns:
1
...
Collateral yield : Interes earned on collateral required to enter into a futures contract
3
...
Greenfield
investments are more uncertainty, might have relative lower yeilds, but might also have greater growth potential
- complete construction of assets / incomplete construction of assets
- Categorise by geographic location
- Sell or lease to the assets to the government / Directly operating the assets

Infrastructure investment Characteristics

- Long life
- Large in cost and scale
- Low liquidity
*** ETFs, mutual funds, PE funds or master limited partnerships (MLPs) provide more liquid investment backed by infrastructure assets

Infrastructure investment - Benefits 1
...
Risks: subjected to
- Regulatory risk
- Risk from financial leverage
- Possibility that CF will be less than expected
- Construction risk - for construction of infrastructure assets
- Operational risk - for assets which are owned an operated by private owner
Other alternative investments

Include: tangible collectibles (e
...
: rare wines, arts, rare coins and stamps, valuable jewelry and watches, sport memorabilia)
Benefits:
- Enjoy the use (collectible automobiles, arts, jewelry and watches)
Risks:
- No income generation
...
g
...
Management fee : earned regardless of investment performance
...
Incentive fee : a portion of profit
...
Organisation: Experience, quality, compensation of management and staff, analysis of prior and current fund results; alignment of manager and investor interests; reputation and quality
of 3rd-party service providers used
2
...
Operations and controls: Reporting and accounting methods; audited financial statements; internal controls, frequency of valuations; valuation approaches; insurance; contingency plans
4
...
Legal review: Fund legal structure; registrations; current and past litigation
6

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