Alternative Investments

1) TAXES: many alt investments are structured as LPs, which require specialized tax expertise

2) SUITABILITY: time horizon or liquidity needs?
3) COMMUNICATION: make sure they understand things like a 10-yr lockout period

4) DECISION RISK: risk of emotionally abandoning a strategy at MAX LOSS point

5) CONCENTRATED POSITIONS: may contain large positions in closely held companies or private residences; may be considered a pre-existing allocation before deciding to add addt'l real estate exposure; may also have large unrealized TAXABLE GAINS

lack of transparency and unique strategies of managers

1) ASSESS MARKET OPPORTUNITY OFFERED: are there exploitable inefficiencies in the mkt the manager is active in?

2) ASSESS INVESTMENT PROCESS: what is manager's competitive edge?

3) ASSESS ORGANIZATION: is it stable and well-run? staff turnover?

4) ASSESS PEOPLE: integrity and competence

5) TERMS and STRUCTURE of INVESTMENT: fee structure? lockout period?

6) ASSESS SERVICE PROVIDERS: lawyers, brokers, etc

7) REVIEW DOCUMENTS: prospectus or private-placement memorandum

8) WRITE-UP: document above review process

benchmark should align style and risk with that of the manager

1) SPECIFIED IN ADVANCE: known to both manager and fund sponsor

2) APPROPRIATE: consistent with manager's investment approach and style

3) MEASURABLE: value and return determined on a reasonably frequent basis

4) UNAMBIGUOUS: clearly defined identities and weights of securities constituting the benchmark

5) REFLECTIVE of the MANAGER'S CURRENT INVESTMENT OPINIONS: manager has current knowledge and expertise of the securities within the benchmark

6) ACCOUNTABLE: manager should accept applicability of benchmark and agree to accept differences in performance btwn the portfolio and benchmark as caused by only his Active Management

7) INVESTABLE: it is possible to REPLICATE the benchmark and Forego Active Management

1) REAL ESTATE: Direct (residences, commercial, agricultural) or Indirect:

-companies that develop and manage property

-REITS

-Commingle Real Estate Funds (CREFs) pooled investments that are professionally managed and privately held; more flexibility than REITs

-SMAs for wealthy investors

-Infrastructure Funds; stable long term returns and cash flows, low correlation, good to match long term liabilities

2) PRIVATE EQUITY: venture capital; Buyout Funds (middle mkt or mega-cap) add value through a) restructuring b) paying below intrinsic value c) adding leverage or restructuring existing debt

3) COMMODITIES: direct or indirect investments

4) HEDGE FUNDS

5) MANAGED FUTURES: derivative mkts; positions based on indices; SD is generally LESS than equities, but greater than bonds; correlation with equities is low and often negative; bond correlation <0.5

6) DISTRESSED SECURITIES

1) Long-Only Value: finding opportunities where prospects will improve; HIGH Yield; ORPHAN Equities (reorganization)

2) Distressed Debt Arb: purchasing distressed debt while shorting equity; return earned in 2 ways: a) if firm declines the equity should fall more bc debt is Senior, b) if company improves, returns to bondholders are higher bc of priority of Interest over Dividends

3) Private Equity: active approach to take some control; VULTURE

-EVENT RISK: can provide diversification benefits

-MKT LIQUIDITY RISK

-MKT RISK: from Macro changes

-J-FACTOR RISK: role that courts or judges can play involving unpredictable human element

1) REAL ESTATE: NCREIF for direct investments; value-weighted, annual appraisal so volatility is downward biased; unsmoothed version is considered the most accurate representation of direct investing

NAREIT Index: for indirect investments; cap weighted, includes all traded REITs, which use leverage and reflects blended characteristics of public equity and RE

infrequent trading of RE understates volatility; unsmoothing tries to correct this bias, but this increases SD and decreases Sharpe Ratio

2) PRIVATE EQUITY: depends on events like IPOs and Mergers; stale data

3) COMMODITY MARKETS: can't use mkt cap method due to zero-sum nature of futures; 2 methods are: a) based on weights of world production, b) based on perceived relative worldwide importance of the commodity

4) MANAGED FUTURES: requires special weighting scheme

5) DISTRESSED SECURITIES: similar to long only HF benchmarks; biases include self-reporting, back fill, inclusion, popularity, survivorship

1) RELEVANCE OF PAST DATA may be questionable; HFs are a reflection of manager skill, so past returns may be LESS RELEVANT to future returns since indices change composition (managers) often

2) POPULARITY BIAS: if one of the fund in a VALUE weighted index increases in value and then attracts a lot of capital

3) SURVIVORSHIP BIAS

4) STALE PRICE BIAS

5) BACKFILL/INCLUSION BIAS: arises from filling in missing past data: directional bias bc only managers who benefit from missing data have an incentive to supply it

ADVANTAGES:

1) many expenses TAX DEDUCTIBLE

2) LEVERAGE: ability to use more leverage than many other investments

3) DIRECT CONTROL of properties

4) GEOGRAPHIC DIVERSIFICATION

5) LOWER VOLATILITY of returns than stocks, even after unsmoothing

DISADVANTAGES:

1) lack of DIVISIBILITY means a single investment may be a large part of investors portfolio

2) HIGH INFORMATION COSTS

3) HIGH COMMISSIONS

4) HIGH OPERATING & MAINTENANCE COSTS

5) SPECIAL GEOGRAPHICAL RISKS (i.e. neighborhood deterioration)

6) POLITICAL RISKS (i.e. changing TAX codes)

Venture Capital Issuers: companies seeking capital

SUPPLIERS (Investors): Venture Capital Funds

corporate venturing: large companies that invest in their own area

angel investors: knowledgeable individuals; often first outsiders

STAGES:

1) EARLY STAGE (seed stage) put up by entrepreneur and/or family to begin prototype; START-UP funds to begin product development & marketing; FIRST STAGE funding for manufacturing & sales

2) EXPANSION STAGE: can be young companies with established product looking to expand, or bigger companies funding GROWTH; 2nd STAGE financing for further production; 3rd Stage same

mezzanine/bridge financing used to prepare for IPO and may include both debt & equity

3) EXIT STAGE: IPO, merger, acquisition

1) RELATIVE VALUE: exploit price discrepancies; equity mkt neutral, convert arb, fixed-income arb

2) EVENT DRIVEN: invest with SHORT TERM focus (merger arb, distressed)

3) EQUITY HEDGE: long/short equity positions, varying overall net long/short; CAN include Leverage

4) GLOBAL ASSET ALLOCATORS: long/short positions in variety of financial and non-financial assets

5) SHORT SELLING

1) CONVERTIBLE ARB: exploit mispricings in converts; buy undervalued converts and short stock which hedges against stock price changes, interest earned from bond coupons and investing proceeds of short, benefits if stock volatility increases (value of embedded call in convert increases)

2) DISTRESSED SECURITIES: undervalued due to illiquidity, difficult to short, not available to many investors

3) EMERGING MKTS

4) EQUITY MKT NEUTRAL: combines long and short undervalued and overvalued securities (pairs trading) to eliminate systematic risk

5) HEDGED EQUITY STRATEGIES: exploit mispricings but do NOT seek to remove systematic risk; may be NET LONG/SHORT on manager's view

6) FIXED INCOME ARB: positions based on expected changes in yield curve or credit spread

7) GLOBAL MACRO: focus on entire group instead of individual securities

8) MERGER ARB

9) FUND OF FUNDS

Diversity and Lack of Transparency

1) HARD TO CALCULATE RETURNS: some funds are long and short and hold minimal capital in relation to total positions, r=(V1-V0)/V0 which is tough to interpret when V0 is very small

2) one approach is VALUE-ADDED RETURN = Portfolio - Benchmark

complicated when managers trade frequently; wide range of funds classified as Hedge Funds makes it difficult to define a benchmark applicable to ALL funds

3) some funds TARGET ABSOLUTE RETURN and argue comparison benchmarks are irrelevant

4) some funds have clear styles and others do not

5) some use SHARPE RATIO to compare managers, but still have the same problem identifying COMPARABLE MANAGERS; also SD use is questionable when many hedge funds show Skewed Returns

1) Real Estate: reacts to macro changes differently than stocks or bonds; each investment has a large unsystematic risk element

2) Private Equity: less for diversification, more for long term return enhancement; often has minority discount associated; PE returns typically move with stock returns but correlations often positive and low

3) Commodities: offer Diversification; correlations with stocks and bonds low and often Negative; strong positive correlation with inflation (except for agricultural commodities)

4) Hedge Funds: higher absolute and risk adjusted returns than stocks and bonds

5) Managed Futures: record similar to hedge funds

6) Distressed Securities: relatively high avg return but LARGE Negative Skew, so avg returns and Sharpe can be misleading

1) Low Liquidity; liquidity premium and higher return

2) Diversification: low correlation to stocks & bonds

3) Due Diligence Costs: higher

4) Difficult Performance Evaluation

1) Real Estate and Long Only Commodities: offer exposure to risk factors and return that stocks and bonds can't provide

2) Hedge Funds and Managed Futures: offer exposure to special investment strategies and are heavily dependent on manager skill

3) Private Equity and Distressed Securities: combination of 1 and 2

1) Storability: storable commodities (precious metals, energy) tend to INCREASE in value with unexpected increases in inflation

Non-storable commodities (agricultural) values negatively affected by unexpected inflation

2) whether commodity's demand is linked to Economic Activity

-those that enjoy more or less constant demand (agricultural) provide Little Hedge

Buyout Funds usually have:
-higher leverage

-earlier and steadier cash flows

-less error in measurement of returns since more returns are from cash flow

-less frequent losses

-less upside potential

-Low Liquidity: allocation should be <5% with plans to keep $ invested 7 to 10 yrs

-Diversification Through a # of Positions; direct PE is only for very large portfolios; smaller portfolios for which PE investing is suitable should use PE funds

-Diversification Strategies

-Plans for Meeting Capital Calls: committed funds are called as needed, so investor must be prepared

Total Return=Spot Return+Collateral Return+Roll Return

Roll Return=change in futures price - spot return

Collateral Return -> periodic risk-free return (positive)

Roll Return: Backwardation (downward sloping term structure) predicts Positive roll return as futures prices increase to converge w spot at expiration (spot assumed to stay the same)

Contango (upward sloping term structure of prices)