L1 flash cards alternative investments (ss18)

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L1 flash cards alternative investments (ss18)

  1. 1. Open-end and Closed-end Funds Open-end and Closed-end funds are classes of investmentfunds.Study Session 18, Reading 66Open-end Funds a type of mutualfund that does nothave restrictions on theamount of shares thefund will issueClosed-end Funds have a finite amount ofcapital the fund manager willinvest. Shares are priced inthe secondary market wherethey are traded (and cantrade at a premium ordiscount to their net assetvalue)
  2. 2. Calculating the Net Asset Value ofInvestment Funds Net Asset Value (NAV) = Market value of the FundPortfolio amount ($) / Number of unitsFor example:NAV = $100 / 10 (units) = $10 per unitStudy Session 18, Reading 66
  3. 3. Nature of Fees Charged byInvestment Companies Management fees are the total fees charged by investmentcompanies to its investors. (i.e. operating expenses,administrative expenses and distribution fees) Expense Ratio = Operating Expenses/Average Asset Size (fundsunder management)Study Session 18, Reading 66
  4. 4. Open-end and Closed-end Funds Fees can be described as either front end loaded or back endloaded.Study Session 18, Reading 66Front end loaded charged by investmentcompanies as salescommissions at the timeof purchase or as fee forarranging thetransaction.Back end loaded charged by investmentcompanies to discourageinvestors from switchingfunds (i.e. exit fees)
  5. 5. Investment Strategies Equity investment strategies can be characterized as global,index, sector, style or stable value strategies. If an equity investor takes a long position:-in high P/E stocks, they may be adopting a growthinvestment strategy-low P/E stocks, they may be adopting a value strategyStudy Session 18, Reading 66
  6. 6. Investment Strategies Large capitalization stocks are less risky and less volatile thansmall stocks, which have lower product diversification. Hence,small cap stocks generate higher earnings than large capstocks. International funds invest in securities of foreign countrieswhereas global funds may hold securities of both home andforeign securities.Study Session 18, Reading 66
  7. 7. Investment Strategies Sector specific investment funds concentrate on investingin a particular industry. An index fund holds an identical portfolio the aninvestment index (i.e. same stocks and weights) Stable value funds invest in short term debt instrumentswith guaranteed principal and a fixed interest rate.Study Session 18, Reading 66
  8. 8. Exchange Traded Funds an investment fund which can be bought/sold likecompany shares on a stock market essentially track a specific index, sector/industry, fixedincome index etc.Study Session 18, Reading 66
  9. 9. Exchange Traded Funds Global ETF invest in global securities In the US, ETF have adopted three different types of legalstructures: Managed Investment Companies Unit Investment Trusts Grantor TrustsStudy Session 18, Reading 66
  10. 10. Exchange Traded Funds If demand for an investment funds exceeds supply, authorizedparticipants generate a creation unit and relevant stocks aredeposited to the trustee according to the appropriate weightsrequired to track the index. To sell an ETF, an authorized participant will exchange aredemption unit with the relevant fund.Study Session 18, Reading 66
  11. 11. Traditional Mutual Funds vsClosed-end FundsTraditional Mutual Funds have an infinite possiblenumber of units whichcan be created asinvestors buy or sellunits in the fund.*Also known as open endfundsClosed-end Funds have a stable number ofunits which fluctuate inprice according to demandor supply of investmentunitsStudy Session 18, Reading 66
  12. 12. Exchange Traded Funds ─ Advantages provide diversification benefits to investors, with low transactioncosts. can be shorted and purchased with margin loans take futures and options positions over their index Unlike closed-end funds, ETFs do not trade at heavy discounts orpremium to NAV. If the value of the ETF varies from its NAV, aninvestor can take advantage of an arbitrage opportunity.Study Session 18, Reading 66
  13. 13. Exchange Traded Funds ─ Advantages In contrast to Mutual Funds: traded during trading hours (MF can only be traded once a day) provide investors with greater transparency as they publishportfolio positions daily relatively cost effective capital gain tax is lower dividends are immediately reinvestedStudy Session 18, Reading 66
  14. 14. ETF─ Disadvantages mainly holds large capitalization stocks attract longer term investors; intraday trading is not required For larger corporations, direct investment in an index can be aperfect substitute for an ETF. Alternatively, an investor mayinvest in an actively managed international fund which mayhave a lower cost and lower taxes.Study Session 18, Reading 66
  15. 15. Exchange Traded Funds ─ Risks market risk is the same as other managed portfolio that arewell diversified may carry asset class and sector risk trading risk – depth and liquidity fluctuates in secondarymarkets tracking error risk – index value and NAV may differ as well derivatives risk – ETFs are exposed to credit risk and increasedleverage currency risk – for ETF invested in international indicesStudy Session 18, Reading 66
  16. 16. Types of Exchange Traded Funds Domestic Market Index – track a stock market index of aspecific country Style – may vary, but can include small, mid and large market-cap, value and growth etc. Sector – technology, telecommunications, media, insuranceetc. Foreign country or regions Fixed Income Commodity Actively Managed FundsStudy Session 18, Reading 66
  17. 17. Real Estate Investments the most common form of tangible asset investment Insurance companies and pension funds favour real estate asan asset class. The 4 types of real estate investment are:1) Clear and Free Equity2) Leveraged Equity3) Mortgages4) Aggregation VehiclesStudy Session 18, Reading 66
  18. 18. Types of Real Estate Investments1. Clear and Free Equity – direct purchase of property without amortgage2. Leverage Equity–ownership rights are given to the investoron the basis of the promise to return the property to thelender if he fails to meet the terms of the loan3. Mortgages– investor receives principal and interestpayments, in return for providing initial capital to thepurchaser of the propertyStudy Session 18, Reading 66
  19. 19. Types of Real Estate Investments4. Aggregation Vehicles – accumulates investors and providesthem with easy access to real estate investment─Common forms include: Real Estate Limited Partnerships (RELPs) Commingled Funds Real Estate Investment Trusts (REITs)Study Session 18, Reading 66
  20. 20. Forms of Aggregation Vehicles RELP – allow investors to act as limited partners so that theycan invest in real estate projects, while outsourcing themanagement rights of the property. Commingled fund –investors come together to invest in realestate projects, which can be closed or open end funds.Study Session 18, Reading 66
  21. 21. Forms of Aggregation Vehicles REITs– closed-end investment companies that issue shares whichis trade on the stock market– allows smaller investors the ability to buy real estate,– traded on the stock market and may trade at a premiumor discount to the NAV of the portfolioStudy Session 18, Reading 66
  22. 22. Characteristics ofReal Estate Investments Property is immovable and indivisible Property can be compared with similar properties although itcan be difficult Market value is hard to assess, no international or localplatforms for this trade Management and transaction costs are higher Market is relatively inefficient because of informationdeficiency.Study Session 18, Reading 66
  23. 23. Real Estate Valuation Real estate valuation differs from other asset classes, given theunique nature of real estate assets and its relative illiquidity5 key approaches:1. Cost Approach2. Sales Comparison Approach3. Hedonic Price Estimation4. Income Approach5. Discounted After Tax Cash Flow ApproachStudy Session 18, Reading 66
  24. 24. Real Estate Valuation Approaches Cost Approach – Calculated as replacement cost (i.e.estimated value of the land and then the cost of building) Sales Comparison Approach – A benchmark value is set forsimilar properties and then a price is quoted on a property. Hedonic Price Estimation – Major characteristics candetermine the value of a property.Study Session 18, Reading 66
  25. 25. Real Estate Valuation Approaches Income Approach – A perpetuity discount model is used for thevaluation of property, with the perpetuity cash flow discountedat the required rate of return. Discounted After Tax Cash Flow Approach – Value of theproperty is the discounted sum of the after tax cash flows thatthe property is expected to derive.Study Session 18, Reading 66
  26. 26. Real Estate Pricing Approaches Income Approach – the perpetuity discount model is used:Appraisal Price = (NOI)/(Market Cap Rate) The market cap rate is derived from recent transactions and issolved by finding the discount rate used to discount futureincome to make it equal to the market value of the property.Market Cap Rate = (Benchmark NOI)/(Benchmark transaction price)Study Session 18, Reading 66
  27. 27. Income ApproachGiven: NOI=$83,800 Depreciation=$18,700Mortgage Payment=$59,404 Purchase Price=$700,000NOI Growth Rate = 5% Marginal Income Tax Rate = 31%To calculate after tax cash flow for year one:$560,000 is 80% of $700,000 10% of $560,000=$56,000Income after tax will be ($83,800 - $18,700 - $56,000) x (1 – 0.31) = $6,279Principal Payment = Mortgage Payment – Interest Payment$3,404= $59,404 - $56,000Hence Cash Flow after tax for the 1st year = $6,279 + $ 18,700 - $3,404 = $ 21,575Study Session 18, Reading 66
  28. 28. Real Estate Pricing Approaches The benchmark method can be based on a single transactionor an average of recent transactions. The valuation derived from the growth dividend discountmodel is equal to the income approach valuation if rentalgrowth rates are assumed to be constant.Study Session 18, Reading 66
  29. 29. Private Equity Private equity is a private, unlisted investment Investors enter limited partnerships with limited liability andhand over the management to the private equity business toprofessional investors.Study Session 18, Reading 66
  30. 30. Types of Private Equity Investment Venture Capital─Investments in ventures from initial stage to the stage wherethe company is able to sell its products. Eventually the privateequity shareholders exit.Study Session 18, Reading 66
  31. 31. Types of Private Equity Investment Leverage Buyouts─ Investors take over a targeted company by acquiringmajority control (buying 20– 40% of the company’s equity, andborrowing the rest)─ The companies are normally publicly traded but delisted,making it a private company─ Investors typically aim to sell out the company within a fewyears, often via an IPOStudy Session 18, Reading 66
  32. 32. Types of Private Equity Investment Distressed Investing─ Investors take a long position in debt/equity securities ofcompanies in distress.─ Generally, they look for companies which are operationallysound, and look to restructure/reorganise them.Study Session 18, Reading 66
  33. 33. Stages of Venture Capital Investments Seed stage – funding given for a business idea Early stage – funding where the capital is given to thecompany to start its operations Formative stage – funding includes seeding and early stagesStudy Session 18, Reading 66
  34. 34. Stages of Venture Capital Investments Later-stage is before the investors raise capital via an IPO andafter manufacturing and sales have commenced. Second stage – funds needed for expansion Third stage – funds for major expansion Mezzanine (also known as bridge financing) is providedfor a company to prepare for going publicStudy Session 18, Reading 66
  35. 35. Challenges of Investing inVenture Capital Illiquidity - highly uncertain cash flows Long-term commitment is required Determining current market value is difficult Limited historic risk and return information Limited information Entrepreneurial mismatchStudy Session 18, Reading 66
  36. 36. Challenges of Investing inVenture Capital Fund manager incentive mismatch Ignorance of competition Vintage cycle Extensive operational analysis needed LiquidationStudy Session 18, Reading 66
  37. 37. Performance Measurement Challenges Fund managers are unable to accurately price ongoingprojects, hence are unable to measure performance. Lack of benchmarks to compare performance. Lack of reliable long term performance data.Study Session 18, Reading 66
  38. 38. Venture Capital Valuation In order to value a Venture Capital investment, an investorneeds to make assumptions regarding: Assessment of payout at the time of exiting the project Assessment of time it will take for the venture to becomesuccessful Assessment of failure probabilityStudy Session 18, Reading 66
  39. 39. Venture Capital ValuationFor Example:An investor wants to invest $1m and expects $16m return in 7 yearstime. The project has a failure probability of 0.25 (1st year), 0.22 (2nd year) and0.2 (3rd year till the 7th year)Probability that the project will survive = (1 – 0.25) (1 – 0.22) (1 –0.20)5= 0.192 or 19.2%NPV of $16m project if it is a success is $4.02mNPV of $16m project if it is a failure is -$1.00mExpected NPV = (0.192)($4.02m) + (0.808)(-$1m) = -$36,160Study Session 18, Reading 66
  40. 40. Hedge FundsObjective of Hedge FundsOriginally hedge funds were created to allow investors used tobet against the market. However, the evolution of hedge fundshas meant that the purpose and scope of these funds hasbroadened significantly.Study Session 18, Reading 66
  41. 41. Hedge FundsLegal Structure of Hedge Funds setup as limited partnership or limited liability corporations hedge fund managers can take short/long positions in anyasset, using derivatives and leverage at its discretionStudy Session 18, Reading 66
  42. 42. Hedge FundsFee Structure of Hedge FundsHedge fund managers are paid a base management feedepending on the asset size. Additionally, they receive anincentive fee if returns exceed cost of capital.Study Session 18, Reading 66
  43. 43. Fund of Funds InvestingFunds of Funds (FOF) created for the easy access of small andinstitutional investors.Benefits Diversification – exposure to a no. of hedge funds Access –exposure to hedge funds closed to new investors Expertise –expertise in finding good performing hedge funds Due diligence process – able to handle due diligence of hedgefundsStudy Session 18, Reading 66
  44. 44. Leveraging Hedge funds may use financial leverage to magnify returns butit also magnifies losses. Managers can create leveraging while trading by: Shorting more equity that they are trading Brokerage accounts provide borrowing on their marginaccounts Financial instruments and derivativesStudy Session 18, Reading 66
  45. 45. Risks of Hedge Funds Liquidity Risk - in case of illiquidity in a market, hedge fundsusing leverage can incur significant losses if positions moveagainst them Pricing Risk –margin calls can create major cash liquidityproblems Counterparty Credit Risk – can arise as hedge funds invest inover the counter derivativesStudy Session 18, Reading 66
  46. 46. Risks of Hedge Funds Settlement Risk – exposed by counterparties on settlementday Short Squeeze Risk – when the price of a stock that a hedgefund has a short position in rises Financing Squeeze –when a hedge has to raise capital to meetthe commitments (i.e. borrowing capacity, margin calls, marking tomarket of positions).Study Session 18, Reading 66
  47. 47. Hedge Fund Indices Historical performance of hedge fund indices may overstateactual returns from this asset class due to a series of biases. The most common biases include:1. Self Selection Bias2. Backfilling Bias3. Survivorship BiasStudy Session 18, Reading 66
  48. 48. Biases Affecting Hedge Fund Indices Self-Selection Bias: Managers with a poor track record will nothave their past performance included in the database Backfilling Bias: Only hedge funds with good track record enterthe database. Survivorship Bias: Hedge fund data only includes data of fundsthat have survived over the entire sample periodStudy Session 18, Reading 66
  49. 49. Effect of Biases on Risk MeasuresBiases also affect a funds risk measures as they: Smooth pricing of assets traded infrequently like privateequity or real estate Invest in strategies with characteristics like options Gaming fee structuresStudy Session 18, Reading 66
  50. 50. Effect of Biases on Hedge Fund IndicesFor example:A hedge fund manager starts 5 new funds. After a couple ofyears, three of the funds keep posting negative returns andmanager decides to close down the poor performing funds.Following this, the manager submits the performance data ofthe remaining two funds to a well known database of hedgefund performance. Hence, only adding the best performingfunds to the database is misleading and a clear case ofsurvivorship bias. This overstates the attractiveness of hedgefund investing.Study Session 18, Reading 66
  51. 51. Effect of Survivorship Bias onHedge Fund DatabaseOnly hedge funds that have survived over the entiremeasurement period are included in the calculation of a hedgefund index performance. Therefore, the returns exclude theperformance of funds which have ceased to exist over thesample period. Hedge fund indices tend to overstate true fundperformance by excluding the worst performing funds.Study Session 18, Reading 66
  52. 52. What are Closely Held Companies? Closed held companies are not frequently traded or listed onthe stock exchange. Inactively traded securities are companies that are illiquid,have less information available, and low dispersion of owners.Study Session 18, Reading 66
  53. 53. Legal Environment Closely held companies can be formed as Special Corporationswhich have special tax advantages. Valuation of closely held companies and not actively tradedshares require proper knowledge of the law and the reasonsfor undertaking the valuation in order to address the taxationimplications of a change in ownership.Study Session 18, Reading 66
  54. 54. Valuation of Closely Held Companies1. Cost Approach –valuation at the cost to replace the assets of thecompany2. Comparable Approach – a benchmark is made by choosing one orthe average of a few similar actively traded companies3. Income approach –discounting future expected income streams.4. Premium/Discount Approach - adjusting the valuation to accountfor relative illiquidity, marketability, and level of control of theshareholdingStudy Session 18, Reading 66
  55. 55. Distressed Investing Investing in distress securities is a type of venture capitalinvesting and is considered a form of value investing. A company that has distressed securities either has alreadyfiled or near to filing for bankruptcy. In US there are two typesof bankruptcy options: Protection of liquidation Protection of reorganizationStudy Session 18, Reading 66
  56. 56. Distressed Investing: Benefits Distressed companies tend to trade at a low enterprise value(EV) to EBITDA multiple. Therefore, there can be significantreturns to investors if the company is able to boost cash flowsfollowing the restructure, as it may also result in an expansionof the EV/EBITDA multiple.Study Session 18, Reading 66
  57. 57. Analysing Distressed Securities Is the company in financial distress (high leverage) or are itsoperations suffering significant? What will drive an improvement in the performance of thebusiness: Cost cutting Improvement in business cycle New management New strategyStudy Session 18, Reading 66
  58. 58. Distressed Security Investing &Venture Capital Investing Distressed security investing shares some similarcharacteristics to venture capital investing as they both havelow liquidity, requires a lot of time, and needs significantinvestor attention.Study Session 18, Reading 66
  59. 59. What are Commodities?Types of Commodities Agricultural (canola, coca, coffee, corn, wheat , sugar, and etc) Energy (i.e. crude oil, gas oil, heating oil, natural gas and etc) Metals (gold, silver, copper and etc)Study Session 18, Reading 66
  60. 60. Why Invest in Commodities? Passive investment – is made through futures contracts for riskdiversification purposes Active investment –commodity prices provide a hedge againstinflation and are linked to the real economic growthStudy Session 18, Reading 66
  61. 61. Why Invest in Commodities? Diversification Monitoring liquidity Volatility Quantitative risk management Budgeting of risk Leverage limits derivative hedging for managing currency risk Performance adjustment risk-wiseStudy Session 18, Reading 66
  62. 62. Contango Occurs when commodity prices are high and volatile. Howeverthe price of futures contract has a ceiling which it cannotbreak because of a “carry trade”. future price > spot priceStudy Session 18, Reading 66
  63. 63. Backwardation The exact opposite of Contango Future price < spot price Is a threat to producers of the commodity as it becomes abusiness risk. Natural backwardation –a fall in price has a greater impact onthe few producers as compared to the consumers.Study Session 18, Reading 66
  64. 64. Carry Trade limits the futures price of a commodity to a limit known as‘fully carry’. In the case of Gold, the futures price would normally betouching fully carry In cases like ‘Hogs’, which have finite lives, full carry do notapply, hence the future prices can be higher than the fullycarry priceStudy Session 18, Reading 66
  65. 65. Carry Trade When an investor buys a futures contract, it deposits moneyknown as collateral. The money deposited generates returnknown as ‘collateral yield’. When a futures contract matures, it finishes and anothercontract is bought that has a longer maturity, this trade isknown as ‘rolling the contract’.Study Session 18, Reading 66
  66. 66. Sources of Returns when Investingin Commodity Derivatives1. Collateral yield – money deposited when entering into aderivative position2. Roll yield (‘convenience yield’) – the return when thematurity of derivative is renewed for longer period oftime3. Spot price return – fluctuations in the value of thecommodityStudy Session 18, Reading 67
  67. 67. Commodity Controversies Commodity prices may decline because of the introduction innew technology or increase in supply. The demand of commodities that can be stored increases witheconomic growth. There is an inverse relationship between acurrency’s purchasing power parity and commodity prices.Study Session 18, Reading 67
  68. 68. Investing in Commodity Derivatives:Roll yield and Rolling Costs Roll yield –has always existed in the past even in the situationof backwardation Rolling Costs –If an investor chooses to roll over a contract atthe maturity of a futures contract, it comes at a cost of sellingthe matured contract and buying the new one. Rollover costscan be reduced via active roll maturity.Study Session 18, Reading 67
  69. 69. Investing in Commodity Derivatives:Return Premium Controversy geometric mean returns of the average commodity is almostzero geometric mean of a commodity index has been strong.Ave. Volatility of the Index < Ave. Volatility of the ComponentsThis occurs because index funds require rebalancing after largecommodity price movements.Study Session 18, Reading 67
  70. 70. Benefits of AddingCommodities to a Portfolio its negative correlation with other asset classes is an attractivefeature for maximising diversification benefits provides natural inflation hedge, a feature beneficial inadopting an inflation matching strategy Utility arbitrage - investors with diff. objectives to transferbetween themselves and maximise group investor utilityStudy Session 18, Reading 67
  71. 71. Institutional Ownershipof Commodities Commodity markets are changing because of increasedinterest in commodities from institutional investors. Institutions money is derailing the commodity market from itsfundamentals. However the divergences between price andfundamental value will eventually revert over time.Study Session 18, Reading 67
  72. 72. Why a Commodity IndexStrategy is Active Commodity index funds are active investments because ofhigh fund turnover. This is driven by a change in constituentweights, a rolling methodology is implied, and cash collateralpositions are continuously reinvested as short term cashequivalents.Study Session 18, Reading 67

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