Analysis of Managed Products

CHAPTER 20: Alternative Investments:

Benefits, Risk, and Structure

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Introduction to Alternative Investments
Definition : Asset classes that are different from the traditional three broad
asset classes: equities, bonds, and cash.
 Three groups: alternative strategy funds, alternative assets
(commodities,, real estate, collectibles).
Alternative Strategy Funds: no restrictions on short selling, leverage,
derivatives, illiquid investments.
Relative Value –profit by exploiting discrepancies in pricing of stocks,
bonds, etc.
Event driven –maintain position in companies under going mergers,
buyback, consolidations, etc.
Directional –profit from anticipated movement in prices of stocks,
bonds, currencies, etc.

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Introduction to Alternative Investments
Alternative Assets
•Real assets held directly or indirectly
•Real assets: Real estate, Collectibles, Infrastructure, Natural Resources
Commodities (precious metals, agriculture products, etc.).

Private Equity
•Comprises of common stock, preferred stock, debt securities that are not
traded publicly.
•The Private equity itself trades on the exchange.

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Investing in Alternatives –Benefits and Risk
Benefits
 Diversify portfolio –when added to a
portfolio, it helps to decrease the risk at a
faster rate than the decrease in the return in
the portfolio.
 Add alpha- this is a measure of the
manager’s performance. The greater the
alpha the better return on the portfolio.
 Increase absolute return – to make the
portfolio more resistant to capital erosion.
 Efficient Frontier

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Investing in Alternatives –Benefits and Risk

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Investing in Alternatives –Benefits and Risk
RISK
• Measurement:
 1. volatility measure by standard deviation.
 2. drawdown amount –maximum percentage decline in the
fund NAV over a specified period of time.
First order risk –changes in the values of equities, fixed income,
currency, etc. Systematic –can’t be changed.
Second Order risk- liquidity, leverage, trading, concentration,
mergers, default, incorrect pricing, modelling, etc
Operational risk –failure in operations of the company, eg
accounting, settlement, management, etc.

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Alternative Investment Structures –Hedge
Funds
What is a hedge fund?

• Lightly regulated pools of capital whose managers have great

flexibility in their investment strategies.
• Managers can: take short positions, use derivatives for
leverage and speculation, perform arbitrage transactions.
• Absolute returns are key : Managers can invest in any market
in any situation where they believe an opportunity for positive
returns exists

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Alternative Investment Structures –Hedge
Funds
Who can invest in hedge funds. Those who qualify under
these exemptions.
a) Minimum investor exemption
b) Accredited investor exemption
c) Offering Memorandum exception

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Alternative Investment Structures –Hedge
Funds
Minimum Investor Exception
Need to invest a minimum of $150,000.
Accredited Investor Exception
Institutional – eg pension funds, trust companies- $5 million.
Individuals:
Must meet at least one of certain minimum requirements:
– own assets having an aggregate value exceeding $1 million.
– net income before taxes exceeding $200k (or $300k if combined
with a spouse) in each of the 2 most recent years.
– Individual or with spouse has $5 million or more in assets
including real estate.

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Alternative Investment Structures –Hedge
Funds
Offering Memorandum Exemption
Subject to a limit of $10,000 per investor.
If the investor is an eligible investor, limit is $30,000
If eligible and gets advise from a portfolio manager, limit
$100,000.
An eligible investor is one who gets confirmation of suitability
from an eligibility advisor who is a registered investment dealer.

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Hedge Fund Features
Incentive Fee:
• A fund begins with $100 million and grows to $120 million in the
first year and the manager is entitled to a 10% incentive fee.
• The manager will earn a $2,000,000 incentive fee (10% of the
$20 million gain).

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Hedge Fund Features
High Water Mark:
• High water mark ensures that a fund manager is paid an
incentive fee only on new profits.
Eg. If the fund declines in value the next year and the incentive fee
is subject to a high-water mark, then no further incentive fee is
paid until the fund rises back over the $120 million previous high.
Hurdle Rate
This is the rate that the fund manager must earn in order to get an
incentive fee.
For example: If the hurdle rate is 5% and the fund earns 15% then
an incentive fee will only be paid on the portion that exceeds 5%
(15-5%) return.

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Hedge Fund Features
Hurdle Rate
This is the rate that the fund manager must earn in order to get an
incentive fee.
No- Watermark
For example: A fund has a hurdle rate of 5% and the fund earns
20% for the year, the incentive fee is based on 15% (20-5).
Watermark
For example: If a fund total return is 25% and it has a hurdle rate
of 5% and a 8% high water mark, then an incentive fee will be
paid on 12% {25- (5 + 8) }.

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Alternative Mutual Funds (Liquid Alts)
• This is a combination of the best aspects of conventional mutual
funds and alternative investments.
• Benefits:
Access to all kinds of investment strategies.
Absolute returns during all phases of the business cycle.
Full transparency, daily liquidity, and investor protection rights.
Lower minimum investment vs hedge funds.
Low fees vs hedge funds.

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Funds of Hedge Funds (FoHF)
• Is a portfolio of hedge funds.
• The manager decides which funds to invest in and the amount of
investment within each.

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FoHF - Advantages
• Reduced volatility
• Professional management
• Access to hedge funds
• Ability to diversify with a smaller investment
• Manager and business risk control

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FoHF - Disadvantages
• Additional costs
• No guarantees of positive returns
• Low or no strategy diversification
• Insufficient or excessive diversification
• Additional sources of leverage

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Alternative Mutual Funds Vs Conventional
Mutual Funds Vs Hedge Funds
Features Conventional mutual Alternative funds – Alternative mutual funds
funds hedge funds

Offering documents Fund Facts, Simplified Oferring memorandum Long From prospectus nad ETF facts
prospectus –if listed, if not listed same as
conventional mfs.
NAV calculation frequency Daily Frequency set by offering same as conventional mfs
memorandum
Continuous Disclosure Mandatory As per offering same as conventional mfs
memorandum
Investment objectives Maximize relative returns Maximize absolute Maximize absolute returns
returns
Permitted investors General public Exempt, accredited, General public
institutional, minimum
$150,000
Redemption Daily Monthly, quarterly Daily

Permitted borrowing 5% of fund NAV Limit set by offering 50 % of fund NAV

memorandum
Right of withdrawal Right to cancel within 48 No right of withdrawal Right to cancel within 48 hours
hours

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