The institute specified reading for this study session is chapter "Alternative Investments" from International Investments by Bruno Solnik and Dennis McLeavey published by Pearson Addison Wesley.
The chapter covers all learning outcome statements of the syllabus.
I prepared material for each LOS based on this source. Each LOS is covered in a separate post.
Showing posts with label Alternative-investments. Show all posts
Showing posts with label Alternative-investments. Show all posts
Sunday, February 3, 2008
Saturday, February 2, 2008
CFA Level 1 Alternative Investments - Investment Companies
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;
Investment companies are financial intermediaries that pool and invest funds of varius individual and institutional investors, giving the investors rights to a proportional share of the pooled fund performance.
There are managed investment companies and unmanaged investment companies in United States.Unit investment trusts in United States are unmanaged investment companies and they hold a fixed portfolio of investments for the life of the company and they stan ready to redeem the investor's units at market value (net asset value) and also for reselling such shares to new investors.
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Unit Investment Trusts (UITs)
A "unit investment trust," commonly referred to as a "UIT," is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.
Here are some of the traditional and distinguishing characteristics of UITs:
A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that the UIT will buy back an investor's "units," at the investor's request, at their approximate net asset value (or NAV) . Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.
A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.
A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.
A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.
A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.
Before investing in a UIT, you should carefully read all of the UIT's available information, including its prospectus.
UITs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 4 and Section 26.
Source:
http://www.sec.gov/answers/uit.htm
------------------------
Managed investment companies are categorised into open-end and closed-end companies
Open-end investment companies are called mutual funds and they stand ready to sell new shares or to redeem existing shares at NAV. Their assets under management expand or contract with each transaction that investors make.
Closed-end investment companies issue shares only once to the public and then those shares are traded in the secondary markets.
NAV calculation of investment companies
NAV is the per-share value of the investment company's assets minus liabilities.
Assets are all the cash and securities that are on its books, accrued dividends &interest payments due to from companies and payments due from stock brokers. Liabilities include payments due to brokers and other parties from whom securities are purchased and will include management fees due to investment managers.
Fees charged by Managers and Management Companies
Investment companies charge fees and also expenses are incurred in transactions and accounting/administration of the fund.
Annual charges comprise management fees, distribution fees and operating expenses.
One time charges at purchase and exit provide commission for sales agent. They do not provide any fee for fund management.
asset value of a fund is calculated and the nature of fees charged by investment
companies;
Investment companies are financial intermediaries that pool and invest funds of varius individual and institutional investors, giving the investors rights to a proportional share of the pooled fund performance.
There are managed investment companies and unmanaged investment companies in United States.Unit investment trusts in United States are unmanaged investment companies and they hold a fixed portfolio of investments for the life of the company and they stan ready to redeem the investor's units at market value (net asset value) and also for reselling such shares to new investors.
------------------
Unit Investment Trusts (UITs)
A "unit investment trust," commonly referred to as a "UIT," is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.
Here are some of the traditional and distinguishing characteristics of UITs:
A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that the UIT will buy back an investor's "units," at the investor's request, at their approximate net asset value (or NAV) . Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are only redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market.
A UIT typically will make a one-time "public offering" of only a specific, fixed number of units (like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which allows owners of UIT units to sell them back to the sponsors and allows other investors to buy UIT units from the sponsors.
A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors.
A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.
A UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust.
Before investing in a UIT, you should carefully read all of the UIT's available information, including its prospectus.
UITs are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, in particular Section 4 and Section 26.
Source:
http://www.sec.gov/answers/uit.htm
------------------------
Managed investment companies are categorised into open-end and closed-end companies
Open-end investment companies are called mutual funds and they stand ready to sell new shares or to redeem existing shares at NAV. Their assets under management expand or contract with each transaction that investors make.
Closed-end investment companies issue shares only once to the public and then those shares are traded in the secondary markets.
NAV calculation of investment companies
NAV is the per-share value of the investment company's assets minus liabilities.
Assets are all the cash and securities that are on its books, accrued dividends &interest payments due to from companies and payments due from stock brokers. Liabilities include payments due to brokers and other parties from whom securities are purchased and will include management fees due to investment managers.
Fees charged by Managers and Management Companies
Investment companies charge fees and also expenses are incurred in transactions and accounting/administration of the fund.
Annual charges comprise management fees, distribution fees and operating expenses.
One time charges at purchase and exit provide commission for sales agent. They do not provide any fee for fund management.
CFA Level Alternative Instruments - Investment Strategies
b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
Style stategies: The funds or fund managers focus on some underlying characteristics common to various possible assets or securities of an asset.
In case of equity growth and value are very popular style strategies.
Growth strategies focus on identifying growth companies selling at high P/E ratios, but undervalued according to the analysis of the fund managers. The fund managers has expertise and confidence in his analysis of growth prospects as well as the valuation of those prospects. Growth style managers are willing to consider new companies for investing.
Value fund managers, rely on past performance to derive a value estimate, and find undervalued companies based on their valuation and then analyze whether there are serious weaknesses that disturb historical record. Value style managersl limit their analysis to companies with having a minimum number of years of existence to get historical data to analyse.
Sector investment funds focus on stocks of particular industry. ex: Pharmaceuticals, Financial industry
An index fund attempts to track an index.
An international fund invests only in foreign assets.
A global fund invests in foreign assets as well as domestic assets.
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
Style stategies: The funds or fund managers focus on some underlying characteristics common to various possible assets or securities of an asset.
In case of equity growth and value are very popular style strategies.
Growth strategies focus on identifying growth companies selling at high P/E ratios, but undervalued according to the analysis of the fund managers. The fund managers has expertise and confidence in his analysis of growth prospects as well as the valuation of those prospects. Growth style managers are willing to consider new companies for investing.
Value fund managers, rely on past performance to derive a value estimate, and find undervalued companies based on their valuation and then analyze whether there are serious weaknesses that disturb historical record. Value style managersl limit their analysis to companies with having a minimum number of years of existence to get historical data to analyse.
Sector investment funds focus on stocks of particular industry. ex: Pharmaceuticals, Financial industry
An index fund attempts to track an index.
An international fund invests only in foreign assets.
A global fund invests in foreign assets as well as domestic assets.
CFA ETFs
Exchange traded funds are index based investment products that allow nvestors to buy or sell exposure to an index on the stock exchange through a single financial instrument.
ETFs are shares of funds that trade on a stock market like shares of any individual companies.
ETFs are shares of funds that trade on a stock market like shares of any individual companies.
CFa Level 1 Advantages and Risks of ETFs
c. explain the advantages and risks of ETFs
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Applications
Implementing asset allocation
Diversifying sector/industry exposure
Gaining exposure to international markets
Equitizing cash
Managing cash flows
Completinng overall investment strategy
Bridging transitions in fund management
Managing portfolio risk
Risks
Market risk
Asset class/sector risk
Trading risk
Tracking error risk
Derivatives risk
Currency risk and country risk
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Applications
Implementing asset allocation
Diversifying sector/industry exposure
Gaining exposure to international markets
Equitizing cash
Managing cash flows
Completinng overall investment strategy
Bridging transitions in fund management
Managing portfolio risk
Risks
Market risk
Asset class/sector risk
Trading risk
Tracking error risk
Derivatives risk
Currency risk and country risk
CFA Level 1 Alt. Inv. Venture Capital
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
---------------------
Private equity investments are equity investments that are not traded on exchanges. private equity definition is now extended to making equity investment through bulk deals involving negotiated prices.
Venture capital falls under private equity definition. Venture capital investments are investments in business ventures from idea stage through expansion of an unlisted company already producing and selling a product. The exit from the investment is made through a buyout or an initial public offering.
Investments in private equity are done through limited partnerhships. Limited partnerships allow participation in funds with limited liability (the initial investment) and management of the fund by general partners who are private equity experts.
Funds of funds are available in private equity funds.
characteristics, and challenges to venture capital valuation and performance
measurement;
---------------------
Private equity investments are equity investments that are not traded on exchanges. private equity definition is now extended to making equity investment through bulk deals involving negotiated prices.
Venture capital falls under private equity definition. Venture capital investments are investments in business ventures from idea stage through expansion of an unlisted company already producing and selling a product. The exit from the investment is made through a buyout or an initial public offering.
Investments in private equity are done through limited partnerhships. Limited partnerships allow participation in funds with limited liability (the initial investment) and management of the fund by general partners who are private equity experts.
Funds of funds are available in private equity funds.
CFA L1 Alt. Inv. Venture Capital Investing
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
Stages of Venture Capital Investing
Seed-stage
Early-stage
Formative-stage
Later-stage
Expansion-stage
Venture capital investment characteristic
Illiquidity
Long-term commitment
Difficulty in determining current market values
Limited historical risk and return data
Limited information
Entrepreneurial management mismatches
Fundmanager incentive mismatches
Lack of knowledge of competitors
Vintage cycles
Extensive operations analysis and advice
types of liquidation
Exits
divestment by trade sale
divestment by IPO/Floatation
Sale of quoted equity
Divestment by writeoff
characteristics, and challenges to venture capital valuation and performance
measurement;
Stages of Venture Capital Investing
Seed-stage
Early-stage
Formative-stage
Later-stage
Expansion-stage
Venture capital investment characteristic
Illiquidity
Long-term commitment
Difficulty in determining current market values
Limited historical risk and return data
Limited information
Entrepreneurial management mismatches
Fundmanager incentive mismatches
Lack of knowledge of competitors
Vintage cycles
Extensive operations analysis and advice
types of liquidation
Exits
divestment by trade sale
divestment by IPO/Floatation
Sale of quoted equity
Divestment by writeoff
CFA Level 1 Alternative Investments - NPV VC Project
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h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
----------
NPV calculation of the venture capital project is done first by calculating NPV in the normal manner as is done for projects of existing companies. The estimates mostly likely cashflows for each year of the project life are made and the cash flows are discounted to present value to determine NPV.
The risk of the venture is explicitly modelled in VC projects. For illustration let use take the following data regarding the probability of failure of a venture.
Year ----Failure probability
1---------------0.30
2.--------------0.25
3.--------------0.20
4.--------------0.15
5.--------------0.15
6.--------------0.10
7.--------------0.10
Becasue probablity of failure is given, probability of success is 1 minus probability of failure. For the first year 0.70 is the probability of success.
The seven years the probability of success is
(0.70)(0.75)(0.80)(0.85)(0.85)(0.90)(0.90) = 0.246
So the probability of venture surviving for seven year is .246.
If the estimate is that the investment outlay required is $2 million and it will give an exit value of 30 million at the end of seven years. The required return is 20%.
The present value of 30 million received at the end of 7 years is 30/(1.20^7) which comes out as 8.372 million.
If project fails at any during seven years the NPV(failure) is -$2 million and if its succeeds NPV(success) is $6.372 million.
The expected NPV of the venture = .754(-$2 mil) + .246($6.372) = $0.06 million
Based on the NPV the venture project can be accepted.
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
----------
NPV calculation of the venture capital project is done first by calculating NPV in the normal manner as is done for projects of existing companies. The estimates mostly likely cashflows for each year of the project life are made and the cash flows are discounted to present value to determine NPV.
The risk of the venture is explicitly modelled in VC projects. For illustration let use take the following data regarding the probability of failure of a venture.
Year ----Failure probability
1---------------0.30
2.--------------0.25
3.--------------0.20
4.--------------0.15
5.--------------0.15
6.--------------0.10
7.--------------0.10
Becasue probablity of failure is given, probability of success is 1 minus probability of failure. For the first year 0.70 is the probability of success.
The seven years the probability of success is
(0.70)(0.75)(0.80)(0.85)(0.85)(0.90)(0.90) = 0.246
So the probability of venture surviving for seven year is .246.
If the estimate is that the investment outlay required is $2 million and it will give an exit value of 30 million at the end of seven years. The required return is 20%.
The present value of 30 million received at the end of 7 years is 30/(1.20^7) which comes out as 8.372 million.
If project fails at any during seven years the NPV(failure) is -$2 million and if its succeeds NPV(success) is $6.372 million.
The expected NPV of the venture = .754(-$2 mil) + .246($6.372) = $0.06 million
Based on the NPV the venture project can be accepted.
Thursday, January 31, 2008
CFA Level 1 Alternative Investments - Hedge Funds - 1
Hedge fund
Objectives,
legal structure,
fee structure, and
classifications of hedge funds;
CFA LOS
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
Reference/Reading: International Investments, by Bruno Solnik and Dennis McLeavey
Solnik and McLeavey say the original concept of a hedge fund was to offer plays against markets, using short selling, futures and other derivative products.
Today the common denominator of hedge funds is not their investment strategy but the search for absolute returns.
Professional money management has progressively moved toward relative performance, performance relative to a bench mark. A fund manager's performance is evaluated relative to some market index which is assigned as a benchmark in his mandate or investment policy document.
The development of hedge funds can be seen as a reaction against this trend and hedge funds try to achieve absolute returns. This means that hedge funds may be termed more appropriately as isolation funds, funds isolated from market trends..
Legal structure: In USA, there are typically set up as a limited partnership, or as limited liability company or as an offshore corporation. These legal structures provide the flexibility to the fund managers to take short positions in any asset, use all kinds of derivatives, and to leverage without restrictions of regulators. In contrast mutual funds are allowed only long positions.
Hedge funds based in United States most often take the form of a limited partnership organized under section 3(c)(1) of the Investment Company Act, thereby gaining exemption from most U.S. Securites and Exchange Commission (SEC) regulations. The fund is limited to no more than 1,009 partners, who must be accredited investors
-----------------
Section 3(c)(1) of the Investment Company Act
c. Further exemptions. Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:
1. Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:
A. Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company's outstanding securities (other than short-term paper).
B. Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.
------------
Some hedge funds in US are organized under section 3(C)(7) of the Investment Company Act. This form also provide exemption from most SEC regulations. In this case, the fund is limited to no more than 500 investors, who have to be qualified purchasers. The fund is prohibited from advertising.
-------------
Section 3(C)(7) of the Investment Company Act.
7.
A. Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
B. Notwithstanding subparagraph (A), an issuer is within the exception provided by this paragraph if--
i. in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if--
I. such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and
II. at the time at which such persons initially acquired the securities of such issuer, the issuer was excepted by paragraph (1); and
ii. prior to availing itself of the exception provided by this paragraph--
I. such issuer has disclosed to each beneficial owner, as determined under paragraph (1), that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and
II. concurrently with or after such disclosure, such issuer has provided each beneficial owner, as determined under paragraph (1), with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for that person's proportionate share of the issuer's net assets.
C. Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to that person's proportionate share of the issuer's net assets, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of such person's share in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).
D. An issuer that is excepted under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.
E. For purposes of determining compliance with this paragraph and paragraph (1), an issuer that is otherwise excepted under this paragraph and an issuer that is otherwise excepted under paragraph (1) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer excepted under paragraph (1) are beneficially owned by not more than 100 persons or whether the outstanding securities of the issuer excepted under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (1).
----------------
As the number of partners is limited, the minimum investment is typically more than $200,000.
Institutional investors can also become partners.
For U.S. hedgefund, Delaware is a fund-friendly state and funds prefer fund friendly states for registration.
Offshore funds also have attractive legal structures and U.S. investors are investing in such funds. Offshore funds are incorporated in British Virgin Islands, Cayman Islands, Bermuda, or such locations that offer fiscal and legal benefits.
Fee Structure
The manager is compensated through a base management fee based on the assets under management (AUM) now typically about 1 percent fo the asset base plus an incentive fee - a percentage of the realized profits (ranging from 15% to 30%, the typical value being 20%). In some agreement, the incentive fee is applied to profits in excess of a specified risk-free-rate. In some agreement, a condition is there that if in some years, the fund declines in value, the fund would first have to recover the decline before realized profit is recognized and incentive fee is paid.
Classification:
Solnik and Mcleavey provide the following classificastion
Long/short funds
Market-neutral funds
Global macro funds
Futures funds
Emerging-market funds
Even driven funds
Distressed securities funds
Risk arbitrage in mergers and acquisitions
Objectives,
legal structure,
fee structure, and
classifications of hedge funds;
CFA LOS
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
Reference/Reading: International Investments, by Bruno Solnik and Dennis McLeavey
Solnik and McLeavey say the original concept of a hedge fund was to offer plays against markets, using short selling, futures and other derivative products.
Today the common denominator of hedge funds is not their investment strategy but the search for absolute returns.
Professional money management has progressively moved toward relative performance, performance relative to a bench mark. A fund manager's performance is evaluated relative to some market index which is assigned as a benchmark in his mandate or investment policy document.
The development of hedge funds can be seen as a reaction against this trend and hedge funds try to achieve absolute returns. This means that hedge funds may be termed more appropriately as isolation funds, funds isolated from market trends..
Legal structure: In USA, there are typically set up as a limited partnership, or as limited liability company or as an offshore corporation. These legal structures provide the flexibility to the fund managers to take short positions in any asset, use all kinds of derivatives, and to leverage without restrictions of regulators. In contrast mutual funds are allowed only long positions.
Hedge funds based in United States most often take the form of a limited partnership organized under section 3(c)(1) of the Investment Company Act, thereby gaining exemption from most U.S. Securites and Exchange Commission (SEC) regulations. The fund is limited to no more than 1,009 partners, who must be accredited investors
-----------------
Section 3(c)(1) of the Investment Company Act
c. Further exemptions. Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:
1. Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:
A. Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company's outstanding securities (other than short-term paper).
B. Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.
------------
Some hedge funds in US are organized under section 3(C)(7) of the Investment Company Act. This form also provide exemption from most SEC regulations. In this case, the fund is limited to no more than 500 investors, who have to be qualified purchasers. The fund is prohibited from advertising.
-------------
Section 3(C)(7) of the Investment Company Act.
7.
A. Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
B. Notwithstanding subparagraph (A), an issuer is within the exception provided by this paragraph if--
i. in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if--
I. such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and
II. at the time at which such persons initially acquired the securities of such issuer, the issuer was excepted by paragraph (1); and
ii. prior to availing itself of the exception provided by this paragraph--
I. such issuer has disclosed to each beneficial owner, as determined under paragraph (1), that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and
II. concurrently with or after such disclosure, such issuer has provided each beneficial owner, as determined under paragraph (1), with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for that person's proportionate share of the issuer's net assets.
C. Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to that person's proportionate share of the issuer's net assets, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of such person's share in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).
D. An issuer that is excepted under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.
E. For purposes of determining compliance with this paragraph and paragraph (1), an issuer that is otherwise excepted under this paragraph and an issuer that is otherwise excepted under paragraph (1) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer excepted under paragraph (1) are beneficially owned by not more than 100 persons or whether the outstanding securities of the issuer excepted under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (1).
----------------
As the number of partners is limited, the minimum investment is typically more than $200,000.
Institutional investors can also become partners.
For U.S. hedgefund, Delaware is a fund-friendly state and funds prefer fund friendly states for registration.
Offshore funds also have attractive legal structures and U.S. investors are investing in such funds. Offshore funds are incorporated in British Virgin Islands, Cayman Islands, Bermuda, or such locations that offer fiscal and legal benefits.
Fee Structure
The manager is compensated through a base management fee based on the assets under management (AUM) now typically about 1 percent fo the asset base plus an incentive fee - a percentage of the realized profits (ranging from 15% to 30%, the typical value being 20%). In some agreement, the incentive fee is applied to profits in excess of a specified risk-free-rate. In some agreement, a condition is there that if in some years, the fund declines in value, the fund would first have to recover the decline before realized profit is recognized and incentive fee is paid.
Classification:
Solnik and Mcleavey provide the following classificastion
Long/short funds
Market-neutral funds
Global macro funds
Futures funds
Emerging-market funds
Even driven funds
Distressed securities funds
Risk arbitrage in mergers and acquisitions
Hedge funds - 2
Fund of funds investing;
----------------------
LOS
j. explain the benefits and drawbacks to fund of funds investing;
-----------------------
Fund of funds have been created in hedge funds.
A fund of funds collects money from small investors and in turn invests in various hedge funds.
It provides investors with the following benefits.
Retailing
As noted earlier, hedge funds requier minimum $200,000 per investor. In the case of fund of funds for the same amount, the investor can get exposure to a large number of hedge funds.
Access
FOF managers can invest in highly successful hedge fund which are closed for subscription as old (existing) investors. Because of their relationships, they can buy partnership or shares of investors leaving the hedgefunds.
Diversification
This benefit is similar to the retailing benefit. In the case of retailing even person with minimum amount gets the benefit of diversification. But in this case benefits of diversification are emphasized for even big investors.
Expertise
The fund managers of FOFs have and develop expertise in finding good quality hedgefunds. Information about hedge funds is limited as they do not advertise. FOF managers buy databases and develop more intimate knowledge of strategies, and their advantages and potential pit falls.
Due Diligence process
There is a due diligence process which needs to be done. Individual investors will find it difficult to do. Even institutional investors may find it cumbersome. An FOF can have better staff resources, procedures and systems to perform the due diligenc process compared to typical institutional investors.
Drawbacks
Fee: Additional fee to FOF managers.
While each hedge fund in which FOF invests charges its fee, FOF charges an additional fee on the AUM. So investors in FOF have to pay an additional fee.
Performance: Past performance based selection is generally done by FOFs. There is little scientific evidence of persistence of performance delivered by FOFs.
Diversification - a two edged sword: Due to diversification FOFs may invest in some high performing funds and some not so high performance funds. So the realized return can be lower than the return of high performance funds.
----------------------
LOS
j. explain the benefits and drawbacks to fund of funds investing;
-----------------------
Fund of funds have been created in hedge funds.
A fund of funds collects money from small investors and in turn invests in various hedge funds.
It provides investors with the following benefits.
Retailing
As noted earlier, hedge funds requier minimum $200,000 per investor. In the case of fund of funds for the same amount, the investor can get exposure to a large number of hedge funds.
Access
FOF managers can invest in highly successful hedge fund which are closed for subscription as old (existing) investors. Because of their relationships, they can buy partnership or shares of investors leaving the hedgefunds.
Diversification
This benefit is similar to the retailing benefit. In the case of retailing even person with minimum amount gets the benefit of diversification. But in this case benefits of diversification are emphasized for even big investors.
Expertise
The fund managers of FOFs have and develop expertise in finding good quality hedgefunds. Information about hedge funds is limited as they do not advertise. FOF managers buy databases and develop more intimate knowledge of strategies, and their advantages and potential pit falls.
Due Diligence process
There is a due diligence process which needs to be done. Individual investors will find it difficult to do. Even institutional investors may find it cumbersome. An FOF can have better staff resources, procedures and systems to perform the due diligenc process compared to typical institutional investors.
Drawbacks
Fee: Additional fee to FOF managers.
While each hedge fund in which FOF invests charges its fee, FOF charges an additional fee on the AUM. So investors in FOF have to pay an additional fee.
Performance: Past performance based selection is generally done by FOFs. There is little scientific evidence of persistence of performance delivered by FOFs.
Diversification - a two edged sword: Due to diversification FOFs may invest in some high performing funds and some not so high performance funds. So the realized return can be lower than the return of high performance funds.
CFA Level 1 Alternative Investments - Hedge Funds - 3
Leverage and unique risks of hedge funds
------------------
LOS
k. discuss the leverage and unique risks of hedge funds;
------------------
Leverage in hedge funds often runs fron 2:1 to 10:1 and can run higher than 100:1.
It is interesting to note that at one point in time, a well known hedge fund that got into problems LTCM, had leverage over 500:1 (Lhabitant, Hedge Funds: Myths and Limits, Jon Wiley, 2002).
Unique risks:
Liquidity risk
The liquidity risk is common to all investors who trade in securities. The risk is much more in the case of trading in illiquid or thin markets. Many hedgefund strategies rely on the presence of liquidity in markets. Because of this, lack of liquidity in extreme market conditions can cause irreversible damage to hedge funds. The failure of the hedge fund Longterm Capital Management (LTCM) was attributed to the unexpected disappearnce of liquidity in the market.
Pricing risk
Hedge funds invest in over the counter traded products. Pricing of those securities or products is a difficult task. In periods of high volatility, broker dealers adopt an extremely conservative policy of pricing them and demand margin based on those prices. This can create severe cash needs for hedge funds to maintain their positions. Pricing risk is more when liquidity is a problem and so they appear together.
Counterparty credit risk
As hedge funds deal in over the counter products, counterparty credit risk arises.
Settlement risk
This is the risk that the counterparty fails to deliver the securities or money involved in a transaction on the settlement day. If the hedge fund planned to utilise the securities or money in turn to settle its other trades, there will be a problem because of settlement failures.
Short squeeze risk
This risk comes into appearance when short sold stock has to be bought at rising prices. This could come about because the lenders of the stock want their stock back. Because some hedge funds use short positions, this can be a risk.
Financing squeeze
If the hedge fund has reached its borrowing limits, and still needs cash to maintain positions by paying margin calls, there is a problem. To tide over the problem, the fund has to square up some its positions under adverse circumstances. This risk is termed financing squeeze risk.
------------------
LOS
k. discuss the leverage and unique risks of hedge funds;
------------------
Leverage in hedge funds often runs fron 2:1 to 10:1 and can run higher than 100:1.
It is interesting to note that at one point in time, a well known hedge fund that got into problems LTCM, had leverage over 500:1 (Lhabitant, Hedge Funds: Myths and Limits, Jon Wiley, 2002).
Unique risks:
Liquidity risk
The liquidity risk is common to all investors who trade in securities. The risk is much more in the case of trading in illiquid or thin markets. Many hedgefund strategies rely on the presence of liquidity in markets. Because of this, lack of liquidity in extreme market conditions can cause irreversible damage to hedge funds. The failure of the hedge fund Longterm Capital Management (LTCM) was attributed to the unexpected disappearnce of liquidity in the market.
Pricing risk
Hedge funds invest in over the counter traded products. Pricing of those securities or products is a difficult task. In periods of high volatility, broker dealers adopt an extremely conservative policy of pricing them and demand margin based on those prices. This can create severe cash needs for hedge funds to maintain their positions. Pricing risk is more when liquidity is a problem and so they appear together.
Counterparty credit risk
As hedge funds deal in over the counter products, counterparty credit risk arises.
Settlement risk
This is the risk that the counterparty fails to deliver the securities or money involved in a transaction on the settlement day. If the hedge fund planned to utilise the securities or money in turn to settle its other trades, there will be a problem because of settlement failures.
Short squeeze risk
This risk comes into appearance when short sold stock has to be bought at rising prices. This could come about because the lenders of the stock want their stock back. Because some hedge funds use short positions, this can be a risk.
Financing squeeze
If the hedge fund has reached its borrowing limits, and still needs cash to maintain positions by paying margin calls, there is a problem. To tide over the problem, the fund has to square up some its positions under adverse circumstances. This risk is termed financing squeeze risk.
CFA Level 1 Alternative Investments - Hedge Funds - 4
------------------------
LOS
l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
------------------------
Performance of hedge funds
Various indexes of hedge funds are available from consultants and fund managers.
Some of them are:
CISDM
Zurich Capital Management and MAR
CSFB/Tremont
VAN
Henesse
EACM 100
HFR
Carr/Barclays for CTAs
Based on the indices Solnik and Mcleavey conclude that there is a strong case for investing in hedge funds.
Hedge funds tend to have a net return (after fees) higher than equity markets and bond markets.
Hedge funds tend to have lower risk(measured by standard deviation of past returns) than traditional equity investments.
Higher Sharpe ratio indicates higher return for a unit of risk. For hedgefunds, data providers do calculate Sharpe ratio and was found to be higher than that for equity investments for the period 1996-2002. But Solnik and Mcleavey raise the caution that Sharpe ration may not be an appropriate measure for hedge funds as they have option like characteristics.
The correlation of hedge fund returns with conventional bonds and equities is positive but low.
Attraction for talent: The fee structure and flexibility of investment options is attracting talented fund managers. When both and long positions and short positions can be taken research insights can be used either way. Also leverage can be employed to magnify the benefit from an insight.
Caveats or cuations:
Investors need to exercise caution in using the available historical performance data on hedgefunds. The hedge fund industry does not adhere to rigorous performance presentation standards as it is not a regulated activity with uniform reporting formats. While past winners may not repeat, certain known biases can make it difficult to interpret the hedgefund performance data. The biases identified are:
Self selection bias
Instant history bias
Survivorship bias
Smoothed pricing - Infrequently traded assets
Option like investment strategies
Fee structure and gaming
There is a very large pool of capital chasing after what is likely to be a limited supply of pricing inefficiencies. Any successful trading strategy will quickly be imitated by many other fund managers, thereby reducing the profitability of the strategy. Investors need to exercise great caution in interpreting and extrapolating the reported performance of hedge funds; there is possibility of underestimating risk.
LOS
l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
------------------------
Performance of hedge funds
Various indexes of hedge funds are available from consultants and fund managers.
Some of them are:
CISDM
Zurich Capital Management and MAR
CSFB/Tremont
VAN
Henesse
EACM 100
HFR
Carr/Barclays for CTAs
Based on the indices Solnik and Mcleavey conclude that there is a strong case for investing in hedge funds.
Hedge funds tend to have a net return (after fees) higher than equity markets and bond markets.
Hedge funds tend to have lower risk(measured by standard deviation of past returns) than traditional equity investments.
Higher Sharpe ratio indicates higher return for a unit of risk. For hedgefunds, data providers do calculate Sharpe ratio and was found to be higher than that for equity investments for the period 1996-2002. But Solnik and Mcleavey raise the caution that Sharpe ration may not be an appropriate measure for hedge funds as they have option like characteristics.
The correlation of hedge fund returns with conventional bonds and equities is positive but low.
Attraction for talent: The fee structure and flexibility of investment options is attracting talented fund managers. When both and long positions and short positions can be taken research insights can be used either way. Also leverage can be employed to magnify the benefit from an insight.
Caveats or cuations:
Investors need to exercise caution in using the available historical performance data on hedgefunds. The hedge fund industry does not adhere to rigorous performance presentation standards as it is not a regulated activity with uniform reporting formats. While past winners may not repeat, certain known biases can make it difficult to interpret the hedgefund performance data. The biases identified are:
Self selection bias
Instant history bias
Survivorship bias
Smoothed pricing - Infrequently traded assets
Option like investment strategies
Fee structure and gaming
There is a very large pool of capital chasing after what is likely to be a limited supply of pricing inefficiencies. Any successful trading strategy will quickly be imitated by many other fund managers, thereby reducing the profitability of the strategy. Investors need to exercise great caution in interpreting and extrapolating the reported performance of hedge funds; there is possibility of underestimating risk.
CFA Level 1 Alternative Investments - Closely Held Companies - 1
Closely held companies
LOS
m. explain how the legal environment affects the valuation of closely held companies;
n. describe alternative valuation methods for closely held companies and distinguish among the bases for the discounts and premiums for these companies;
Reference/Reading" Solnik and McLeavey
Closely held companies are those that are not publicly traded. Inactive traded securities are securities that are infrequently traded; Normally, they are securities traded on minor stock exchanges.
Limited information availability is an issue for analysis of such companies. Illiquidity is an obvious issue. In the valuation of such securites minority ownership issue needs to be brought in.
So the analysis of these securities require evaluation of legal, financial, ownership and illiquidty issues.
Legal Issues:
Closely held companies may be organized in a variety of ways. The options include: special tax advantaged corporations (subchapter S corporations in US), regular coprorations, general partnerships, limited partnerships, and sole proprietorships.
Case law defines terms such as intrinsic value, fundamental value an fair value. Valuation of closely held and inactively traded securities requires extensive knowledge of concerned law and the purposes of valuation.
[Reference: Pratt, s.P., Reilly, R.F., and Schweihs, R.P. Valuing a Business, 3rd ed., Chicago; Irwin, 1996]
LOS
m. explain how the legal environment affects the valuation of closely held companies;
n. describe alternative valuation methods for closely held companies and distinguish among the bases for the discounts and premiums for these companies;
Reference/Reading" Solnik and McLeavey
Closely held companies are those that are not publicly traded. Inactive traded securities are securities that are infrequently traded; Normally, they are securities traded on minor stock exchanges.
Limited information availability is an issue for analysis of such companies. Illiquidity is an obvious issue. In the valuation of such securites minority ownership issue needs to be brought in.
So the analysis of these securities require evaluation of legal, financial, ownership and illiquidty issues.
Legal Issues:
Closely held companies may be organized in a variety of ways. The options include: special tax advantaged corporations (subchapter S corporations in US), regular coprorations, general partnerships, limited partnerships, and sole proprietorships.
Case law defines terms such as intrinsic value, fundamental value an fair value. Valuation of closely held and inactively traded securities requires extensive knowledge of concerned law and the purposes of valuation.
[Reference: Pratt, s.P., Reilly, R.F., and Schweihs, R.P. Valuing a Business, 3rd ed., Chicago; Irwin, 1996]
Wednesday, January 30, 2008
CFA Level 1 Alternative Investments - Closely Held Companies
Closely held companies
LOS
m. explain how the legal environment affects the valuation of closely held companies;
n. describe alternative valuation methods for closely held companies and distinguish among the bases for the discounts and premiums for these companies;
Reference/Reading" Solnik and McLeavey
Closely held companies are those that are not publicly traded. Inactive traded securities are securities that are infrequently traded; Normally, they are securities traded on minor stock exchanges.
Limited information availability is an issue for analysis of such companies. Illiquidity is an obvious issue. In the valuation of such securites minority ownership issue needs to be brought in.
So the analysis of these securities require evaluation of legal, financial, ownership and illiquidty issues.
Legal Issues:
Closely held companies may be organized in a variety of ways. The options include: special tax advantaged corporations (subchapter S corporations in US), regular coprorations, general partnerships, limited partnerships, and sole proprietorships.
Case law defines terms such as intrinsic value, fundamental value an fair value. Valuation of closely held and inactively traded securities requires extensive knowledge of concerned law and the purposes of valuation.
[Reference: Pratt, s.P., Reilly, R.F., and Schweihs, R.P. Valuing a Business, 3rd ed., Chicago; Irwin, 1996]
Alternative Valuation Methods Applicable
The cost approach: Determining what it would cost to replace the assets of the firm or company in their present form and state.
The comparables approach: This approach involves developing a bench mark value based on the market price of similar but actively traded company, or the average or median value of the market prices of similar companies, in transactions made in the period close to the time of appraisal.
To derive the value of the firm or security or company concerned, the benchmark price/value needs to be adjusted for market conditions (there is a possibility that tbere is mispricing either on the lower side or higher side) and the unique features of the firm that differ from benchmark.
The income approach: Methods that Estimate any anticipated future economic income stream and discount them to find the value fall under this approach.
LOS
m. explain how the legal environment affects the valuation of closely held companies;
n. describe alternative valuation methods for closely held companies and distinguish among the bases for the discounts and premiums for these companies;
Reference/Reading" Solnik and McLeavey
Closely held companies are those that are not publicly traded. Inactive traded securities are securities that are infrequently traded; Normally, they are securities traded on minor stock exchanges.
Limited information availability is an issue for analysis of such companies. Illiquidity is an obvious issue. In the valuation of such securites minority ownership issue needs to be brought in.
So the analysis of these securities require evaluation of legal, financial, ownership and illiquidty issues.
Legal Issues:
Closely held companies may be organized in a variety of ways. The options include: special tax advantaged corporations (subchapter S corporations in US), regular coprorations, general partnerships, limited partnerships, and sole proprietorships.
Case law defines terms such as intrinsic value, fundamental value an fair value. Valuation of closely held and inactively traded securities requires extensive knowledge of concerned law and the purposes of valuation.
[Reference: Pratt, s.P., Reilly, R.F., and Schweihs, R.P. Valuing a Business, 3rd ed., Chicago; Irwin, 1996]
Alternative Valuation Methods Applicable
The cost approach: Determining what it would cost to replace the assets of the firm or company in their present form and state.
The comparables approach: This approach involves developing a bench mark value based on the market price of similar but actively traded company, or the average or median value of the market prices of similar companies, in transactions made in the period close to the time of appraisal.
To derive the value of the firm or security or company concerned, the benchmark price/value needs to be adjusted for market conditions (there is a possibility that tbere is mispricing either on the lower side or higher side) and the unique features of the firm that differ from benchmark.
The income approach: Methods that Estimate any anticipated future economic income stream and discount them to find the value fall under this approach.
CFA Alternative Investment - Distressed Securities
Reference/Reading: Solnik and McLeavey
Distressed securities are the securities of companies that have filed or are close to filing for bankruptcy court protection, or that are seeking out-of-court debt restructuring to avoid bankruptcy.
Valuation of distressed securities requires legal, operational, and financial analysis.
Distressed securities are the securities of companies that have filed or are close to filing for bankruptcy court protection, or that are seeking out-of-court debt restructuring to avoid bankruptcy.
Valuation of distressed securities requires legal, operational, and financial analysis.
CAF level 1 Alternative Investments - Commodities - 1
CFA Learning outcome statements
Commodities
p. discuss the role of commodities as a vehicle for investing in production and
consumption;
q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;
r. discuss the sources of return on a collateralized commodity futures position.
Commodities are raw materials that are sold in bulk, such as oil, wheat, silver, gold, oranges and cocoa. They are generally raw materials that are eventually used to produce other goods such as oil for gasoline, cocoa for chocolate, wheat for bread, etc. There is trade in commodities within a country as well as across countries. Most large manufacturers buy the commodities they need on the "spot market," where the full cash price is usually paid on the spot. Speculators typically buy and sell commodities with options and futures contracts.As such, they give an investor/speculator the opportunity to invest in the materials that a country produces and in the materials it consumes.
Commodities
p. discuss the role of commodities as a vehicle for investing in production and
consumption;
q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;
r. discuss the sources of return on a collateralized commodity futures position.
Commodities are raw materials that are sold in bulk, such as oil, wheat, silver, gold, oranges and cocoa. They are generally raw materials that are eventually used to produce other goods such as oil for gasoline, cocoa for chocolate, wheat for bread, etc. There is trade in commodities within a country as well as across countries. Most large manufacturers buy the commodities they need on the "spot market," where the full cash price is usually paid on the spot. Speculators typically buy and sell commodities with options and futures contracts.As such, they give an investor/speculator the opportunity to invest in the materials that a country produces and in the materials it consumes.
CFA Level 1 Alternative Investments - Commodities - 2
Commodities are raw materials that are sold in bulk, such as oil, wheat, silver, gold, pork bellies, oranges and cocoa. They are generally raw materials that are eventually used to produce other goods such as oil for gasoline, cocoa for chocolate, wheat for bread, etc. As such, they give an investor the opportunity to invest in the materials that a country (or corporation) produces as well as those that it consumes. Most larger manufacturers buy the commodities they need on the "spot market," where the full cash price is usually paid on the spot. Speculators typically buy and sell commodities with options and futures contracts.
Types of Commodity Investments
A commodity-linked security refers to a security whose return is dependent to a certain extent on the price level of a commodity, such as crude oil, gold, or silver, at maturity. For example, the principal of a commodity-linked bond is indexed to movements of a commodity index such as precious metal or oil.
Commodity derivatives include both exchange-traded and over-the-counter commodity derivatives such as swaps, futures and forwards. They are used to hedge risk and to take advantage of arbitrage opportunities.
Collateralized Commodity Futurespositions involve taking a long position in the futures contract of your choice and then purchasing the amount equal to your futures position in T-bills. The source of return comes from the interest you earn on your T-bill position and the movement of the futures price.
Motivations for Investing in Commodities, Commodity Derivatives, and Commodity-linked Securities
Commodities offer investors a number of benefits:
Hedge Against Inflation: Commodity cash prices may benefit from periods of unexpected inflation, whereas stocks and bonds may suffer. Commodities are "real assets", unlike stocks and bonds, which are "financial assets". Commodities, therefore, tend to react to changing economic fundamentals in ways that are different from traditional financial assets, particularly with respect to inflation. Commodity prices usually rise when inflation is accelerating, so investing in commodities can give portfolios a hedge against inflation. Conversely, stocks and bonds tend to perform better when the rate of inflation is stable or slowing. Faster inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars will be able to buy fewer goods and services than they would today.
However, this inflation advantage is captured more efficiently by direct investment in commodities than, for example, investment in commodity-related equities whose prices also reflect the financial prospects of the issuer or actively managed commodity futures accounts, which tend to reflect the manager's skills at selecting the right commodities.
Performance/Return: Investor interest in commodities has soared in recent years as the asset class has outperformed traditional assets such as stocks and bonds. Over the five-year period ended March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus 2.6% for the S&P 500. Part of this superior performance is attributable to a rise in commodity prices driven by increased demand from China and other emerging countries.
Enhanced Diversification: Portfolio diversification is the primary benefit of holding commodities. The reason for that is the commodity investor is exposed to commodity futures prices. Changes in those prices reflect changing expectations about future supply and demand for commodities. Factors that change expectations - such as a weather event in the Midwest or a strike in a copper mine in Chile - typically don't have anything to do with stock and bond markets.
Forms of Commodity Investing
Investing in commodities comes in two forms: passive and active:
Passive investing is a strategy used by investors who are using commodities as a risk diversification tool. For example, when inflation picks up, it tends to hurt fixed income securities and equities to some extent. However, prices of commodities tend to rise during these periods. This helps diversify your portfolio. Commodity investing has long had a reputation for exceptional volatility and risk but there is now a small but growing number of excellent, high-quality index-based commodity funds available that provide a relatively conservative way to invest in commodities. The management attempts to minimize price fluctuations and provide overall risk management in several ways. The selection and weighting of assets in a portfolio are typically reviewed annually or when there is a major change in an industry or even a drastic change in usage of any given commodity. This provides some overall risk reduction in commodity index funds and makes them suitable for investment by investors with limited commodity backgrounds.
Index funds usually consist of long positions on the contracts. Short positions are usually not taken.
Active investing or actively managing a position in the commodities market can provide good performance results. In periods of economic growth, commodities are in strong demand to satisfy production needs. Because commodity or raw material prices tend to move more quickly in reaction to economic fluctuations than do the prices of the related finished goods, an active approach could lead to economic gains if trading activities are closely monitored and managed by the investor.
Types of Commodity Investments
A commodity-linked security refers to a security whose return is dependent to a certain extent on the price level of a commodity, such as crude oil, gold, or silver, at maturity. For example, the principal of a commodity-linked bond is indexed to movements of a commodity index such as precious metal or oil.
Commodity derivatives include both exchange-traded and over-the-counter commodity derivatives such as swaps, futures and forwards. They are used to hedge risk and to take advantage of arbitrage opportunities.
Collateralized Commodity Futurespositions involve taking a long position in the futures contract of your choice and then purchasing the amount equal to your futures position in T-bills. The source of return comes from the interest you earn on your T-bill position and the movement of the futures price.
Motivations for Investing in Commodities, Commodity Derivatives, and Commodity-linked Securities
Commodities offer investors a number of benefits:
Hedge Against Inflation: Commodity cash prices may benefit from periods of unexpected inflation, whereas stocks and bonds may suffer. Commodities are "real assets", unlike stocks and bonds, which are "financial assets". Commodities, therefore, tend to react to changing economic fundamentals in ways that are different from traditional financial assets, particularly with respect to inflation. Commodity prices usually rise when inflation is accelerating, so investing in commodities can give portfolios a hedge against inflation. Conversely, stocks and bonds tend to perform better when the rate of inflation is stable or slowing. Faster inflation lowers the value of future cash flows paid by stocks and bonds because those future dollars will be able to buy fewer goods and services than they would today.
However, this inflation advantage is captured more efficiently by direct investment in commodities than, for example, investment in commodity-related equities whose prices also reflect the financial prospects of the issuer or actively managed commodity futures accounts, which tend to reflect the manager's skills at selecting the right commodities.
Performance/Return: Investor interest in commodities has soared in recent years as the asset class has outperformed traditional assets such as stocks and bonds. Over the five-year period ended March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus 2.6% for the S&P 500. Part of this superior performance is attributable to a rise in commodity prices driven by increased demand from China and other emerging countries.
Enhanced Diversification: Portfolio diversification is the primary benefit of holding commodities. The reason for that is the commodity investor is exposed to commodity futures prices. Changes in those prices reflect changing expectations about future supply and demand for commodities. Factors that change expectations - such as a weather event in the Midwest or a strike in a copper mine in Chile - typically don't have anything to do with stock and bond markets.
Forms of Commodity Investing
Investing in commodities comes in two forms: passive and active:
Passive investing is a strategy used by investors who are using commodities as a risk diversification tool. For example, when inflation picks up, it tends to hurt fixed income securities and equities to some extent. However, prices of commodities tend to rise during these periods. This helps diversify your portfolio. Commodity investing has long had a reputation for exceptional volatility and risk but there is now a small but growing number of excellent, high-quality index-based commodity funds available that provide a relatively conservative way to invest in commodities. The management attempts to minimize price fluctuations and provide overall risk management in several ways. The selection and weighting of assets in a portfolio are typically reviewed annually or when there is a major change in an industry or even a drastic change in usage of any given commodity. This provides some overall risk reduction in commodity index funds and makes them suitable for investment by investors with limited commodity backgrounds.
Index funds usually consist of long positions on the contracts. Short positions are usually not taken.
Active investing or actively managing a position in the commodities market can provide good performance results. In periods of economic growth, commodities are in strong demand to satisfy production needs. Because commodity or raw material prices tend to move more quickly in reaction to economic fluctuations than do the prices of the related finished goods, an active approach could lead to economic gains if trading activities are closely monitored and managed by the investor.
CFA LEVEL 1 STUDY SESSION 18 ALTERNATIVE INVESTMENTS
STUDY SESSION 18
ALTERNATIVE INVESTMENTS
Due to diversification benefits and higher expectations of investment returns,
investors are increasingly turning to alternative investments. This study
session describes the common types of alternative investments, methods for their
valuation, unique risks and opportunities associated with them, and the relation
between alternative investments and traditional investments.
Although finding a single definition of an “alternative” investment is difficult,
certain features (e.g., limited liquidity, infrequent valuations, and unique
legal structures) are typically associated with alternative investments. This study
session discusses these features and how to evaluate their impact on expected
returns and investment decisions in more detail. The reading provides an
overview of the major categories of alternative investments, including real estate,
private equity, venture capital, hedge funds, closely held companies, distressed
securities, and commodities.
Each one of these categories has several unique characteristics, and the
readings discuss valuation methods for illiquid assets (such as direct real estate or
closely held companies), performance measures for private equity and venture
capital investments, differences between various hedge fund strategies, and
implementation vehicles for investments in alternative assets.
LEARNING OUTCOMES
Reading 76: Alternative Investments
The candidate should be able to:
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;
b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
c. explain the advantages and risks of ETFs;
d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;
e. describe the various approaches to the valuation of real estate;
f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
j. explain the benefits and drawbacks to fund of funds investing;
k. discuss the leverage and unique risks of hedge funds;
l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
m. explain how the legal environment affects the valuation of closely held
companies;
n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;
o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;
p. discuss the role of commodities as a vehicle for investing in production and
consumption;
q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;
r. discuss the sources of return on a collateralized commodity futures position.
Grouped contents
Mutual fund
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;
b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
ETFs
c. explain the advantages and risks of ETFs;
Real estae
d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;
e. describe the various approaches to the valuation of real estate;
f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;
venute capital
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
Hedge fund
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
j. explain the benefits and drawbacks to fund of funds investing;
k. discuss the leverage and unique risks of hedge funds;
l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
closely held companies
m. explain how the legal environment affects the valuation of closely held
companies;
n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;
distressed
o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;
Commodities
p. discuss the role of commodities as a vehicle for investing in production and
consumption;
q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;
r. discuss the sources of return on a collateralized commodity futures position.
ALTERNATIVE INVESTMENTS
Due to diversification benefits and higher expectations of investment returns,
investors are increasingly turning to alternative investments. This study
session describes the common types of alternative investments, methods for their
valuation, unique risks and opportunities associated with them, and the relation
between alternative investments and traditional investments.
Although finding a single definition of an “alternative” investment is difficult,
certain features (e.g., limited liquidity, infrequent valuations, and unique
legal structures) are typically associated with alternative investments. This study
session discusses these features and how to evaluate their impact on expected
returns and investment decisions in more detail. The reading provides an
overview of the major categories of alternative investments, including real estate,
private equity, venture capital, hedge funds, closely held companies, distressed
securities, and commodities.
Each one of these categories has several unique characteristics, and the
readings discuss valuation methods for illiquid assets (such as direct real estate or
closely held companies), performance measures for private equity and venture
capital investments, differences between various hedge fund strategies, and
implementation vehicles for investments in alternative assets.
LEARNING OUTCOMES
Reading 76: Alternative Investments
The candidate should be able to:
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;
b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
c. explain the advantages and risks of ETFs;
d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;
e. describe the various approaches to the valuation of real estate;
f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
j. explain the benefits and drawbacks to fund of funds investing;
k. discuss the leverage and unique risks of hedge funds;
l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
m. explain how the legal environment affects the valuation of closely held
companies;
n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;
o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;
p. discuss the role of commodities as a vehicle for investing in production and
consumption;
q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;
r. discuss the sources of return on a collateralized commodity futures position.
Grouped contents
Mutual fund
a. differentiate between an open-end and a closed-end fund, and explain how net
asset value of a fund is calculated and the nature of fees charged by investment
companies;
b. distinguish among style, sector, index, global, and stable value strategies in
equity investment and among exchange traded funds (ETFs), traditional mutual
funds, and closed end funds;
ETFs
c. explain the advantages and risks of ETFs;
Real estae
d. describe the forms of real estate investment and explain their characteristics as
an investable asset class;
e. describe the various approaches to the valuation of real estate;
f. calculate the net operating income (NOI) from a real estate investment, the value
of a property using the sales comparison and income approaches, and the
after-tax cash flows, net present value, and yield of a real estate investment;
venute capital
g. explain the stages in venture capital investing, venture capital investment
characteristics, and challenges to venture capital valuation and performance
measurement;
h. calculate the net present value (NPV) of a venture capital project, given the
project’s possible payoff and conditional failure probabilities;
Hedge fund
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
j. explain the benefits and drawbacks to fund of funds investing;
k. discuss the leverage and unique risks of hedge funds;
l. discuss the performance of hedge funds, the biases present in hedge fund
performance measurement, and explain the effect of survivorship bias on the
reported return and risk measures for a hedge fund database;
closely held companies
m. explain how the legal environment affects the valuation of closely held
companies;
n. describe alternative valuation methods for closely held companies and distinguish
among the bases for the discounts and premiums for these companies;
distressed
o. discuss distressed securities investing and compare venture capital investing with
distressed securities investing;
Commodities
p. discuss the role of commodities as a vehicle for investing in production and
consumption;
q. explain the motivation for investing in commodities, commodities derivatives,
and commodity-linked securities;
r. discuss the sources of return on a collateralized commodity futures position.
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