Study Session 18 Alternative Investments

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Study Session 18
Alternative Investments


A. Alternative Investments


a. describe the general features of alternative investments and distinguish between
alternative assets and alternative strategies.

Both alternative assets and alternative strategies are classiIied as alternative
investments.
Alternative assets are assets not traded on exchanges. Examples include real
estate, venture capital, etc.
Alternative strategies are strategies that mostly use traded assets Ior the purpose
oI isolating bets and generating alpha. Examples include hedge Iunds and mutual
Iunds.

Whether an investor invests directly or through an intermediary in alternative
investments, he must know the investment's characteristics. Alternative investments
usually involve:
illiquiditv: since most alternative investments are not traded on exchanges, they
usually cannot be quickly converted to cash at a price close to Iair market value.
As a result, alternative investments beckon investors to areas oI the market where
alpha is more likely to be Iound than in more liquid and eIIicient markets. A
liquidity premium compensates the investor Ior the investor's inability to
continuously rebalance the alternative investments in the portIolio.

difficultv in the determination of current market values.

limited historical risk and return data: the requirement Ior extensive investment
analysis.

a segmentation risk premium: the premium compensates investors Ior the risk oI
alternative assets that, by nature, are generally nor priced in a Iully integrated
global market.

Unique legal and tax considerations: many alternative investments use special
legal structures to avoid some taxes or regulations.

Illiquidity, limited inIormation, and less eIIiciency do not suit all investors, but can be
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attractive Ieatures to those looking Ior likely places to add value through investment
expertise.

Note: alpha is risk-adjusted return in excess oI the required rate oI return, but, more
colloquially, stands Ior positive excess risk-adjusted return, the goal oI active
managers.





b. distinguish between an open-end and a closed-end fund and between a load and
a noload fund.

An investment company invests a pool oI Iunds belonging to many individuals in a
single portIolio (reIerred to as a Iund) oI securities. The major duties oI the
investment management company include investment research, the management oI
the portIolio and administrative duties, such as issuing securities and handling
redemptions and dividends. The management oI the portIolio oI securities and most oI
the other administrative duties are handled by a separate investment management
company hired by the board oI directors oI the investment company. To achieve
economics oI scale, many management companies start numerous Iunds with diIIerent
characteristics. This "Iamily oI Iunds" promotes Ilexibility and increases the total
capital managed by the investment Iirm.


Investment companies are classiIied according to whether or not they stand ready to
redeem investor shares.
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An open-end investment company, or a mutual fund, continues to sell and
repurchase shares aIter its initial public oIIering. It stands ready to redeem
investor shares at market value.

A closed-end investment company operates like any other public Iirm. It is
initiated through a stock oIIering to raise capital. Its stock trades on the regular
secondary market and the market price is determined by supply and demand. A
typical closed-end investment company oIIers no Iurther shares and does not
repurchases the shares on demand (no Iunds can be withdrawn). ThereIore,
investors must trade in public secondary markets (e.g. NASDAQ) to buy or sell
shares.

Various Iees charged by investment companies:

Investment companies charge Iees Ior their eIIorts oI setting up Iunds. Sales
commissions are charged at purchase (front-end load) as a percentage oI the
investment.
A load fund has sales commission charges. A load Iund's oIIering price
NAV oI the share a sales charge (7.5 - 8 oI the NAV). The NAV price is
the redemption (bid) price, and the oIIering (ask) price equals the NAV
divided by 1 minus the percent load.
A no-load fund imposes no initial sales charge, so it sells at NAV. Some
charge a small redemption Iee oI about 0.5.
A low-load fund typically imposes 3 percent sales charge.

Redemption fee (back-end load): a charge to exit the Iund. They discourage
quick trading turnover and are set up so that the Iees decline the longer the shares
are held (in this case, the Iees are sometimes called contingent deferred sales
charges). Load Iunds generally charge no redemption Iees.

All mutual Iunds charge annual Iees.
They are composed oI operating expenses including management Iees,
administrative expenses and continuing distribution Iees. For example,
distribution fees are Iees paid back to the party that arranged the initial sale
oI the shares and are thus another type oI sales incentive Iee.
Annual charges are typically calculated as a percentage oI the average net
assets oI the Iund. For example, a 12b-1 plan permits Iunds to deduct as
much as 0.75 oI average net assets per year to cover distribution costs.
The ratio oI operating expenses to average assets is oIten reIerred to as the
Iund's "expense ratio".



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c. explain how the net asset value of a fund is calculated.

The per-share value oI the investment company is known as its net asset value (NAV).
It is like the share price oI a corporation's common stock.

Fund NAV (Total Market Value of Fund Portfolio) - (Fund Liabilities)] /
(Number of Fund Shares Outstanding)

Fund liabilities are mainly Iees owed to the Iund manager.
Share value equals NAV Ior unmanaged and open-end investment companies
because they stand ready to redeem their shares at NAV.
The price oI a closed-end investment company's shares is determined by the
supply and demand in the secondary markets in which they trade, and,
consequently, can be at a premium or discount to NAV.





d. explain the nature of various fees charged by mutual funds and the impact of
such fees on fund performance.

For diIIerent kinds oI various Iees, please reIer to los b.

In addition to selling charges (loads or 12b-1 charges), all investment Iirms charge
annual management fees to compensate proIessional managers oI the Iund. Such a
Iee typically is Irom 0.25 to 1.00 percent oI the average net assets oI the Iund. These
management Iees are a major Iactor driving the creation oI new Iunds: once the
research staII and management structure have been established, the incremental costs
do not rise in line with the assets under management.

Loads, redemption Iees, and distribution Iees are sales incentives.

Only management Iees can be considered a portIolio management incentive Iee.
However, as management Iees are based on net assets oI the Iund instead oI its
rate oI return, they are not an eIIective perIormance incentive. Researches have
also Iound out that good perIormance is associated with low expense ratios.







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e. distinguish among style, sector, index, global, and stable value strategies in equity
investment.

Investment companies primarily invest in equity. Investment strategies can be
characterized as the Iollowing strategies:

Style strategies Iocus on the underlying characteristics common to certain
investments. Growth is a diIIerent style than value, and large capitalization
investing is a diIIerent style than small stock investing. A growth strategy may
Iocus on high price-to-earnings stocks, and a value strategy on low
price-to-earnings stocks. Clearly there are many styles.

A sector investment fund Iocuses on particular industries (e.g. technology).

An index fund tracks an index. In the simplest implementation, the Iund owns
the securities in the index in exactly the same proportion as the market value
weights oI those securities in the index.

A global fund includes securities Irom around the world and might keep portIolio
weights similar to world market capitalization weights. An international fund is
one that does NOT include the home country's securities, whereas a global Iund
includes the securities Irom the home country.

A stable value fund invests in securities such as short-term Iixed income
instruments and guaranteed investment contracts which are guaranteed by the
issuing insurance company and pay principal and a set rate oI interest. It Iocuses
on preservation oI capital while earning stable current income.




f. distinguish between a closed-end fund and an exchange traded fund (E1F).

Exchange-traded funds (ETF) are a special type oI mutual Iunds traded on a stock
market like shares oI public companies. They are designed to closely track the
perIormance oI a speciIied stock market index.
ETFs can be traded at any time during market hours.
ETFs can be sold short or margined.
ETFs are shares oI a portIolio, not oI an individual company.

Legal Structures oI ETFs

Managed Investment Companies are open-ended investment companies
registered under the Investment Company Act oI 1940.
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They oIIer the most Ilexible ETF structure.
The index can be tracked using various techniques.
Dividends paid on the securities can be immediately reinvested in the Iund.

Unit Investment Trusts (UITs) are also registered investment companies but
operate under more constraints because they don't have a manager per se (but
trustees)
They are required to be Iully invested in all underlying securities Iorming the
index.
They must hold dividends received on securities in cash until the ETF pays a
dividend to shareholders: this could result in a slight cash drag on
perIormance.
They are not permitted to lend securities and do not generally use derivatives.

Grantor Trusts are a structure that allows investors to indirectly own an
unmanaged basket oI stocks rather than tracking an index. They are not registered
investment companies.
Because a grantor trust is Iully invested in the basket oI securities, no
investment discretion is exercised by the trust. This is basically an
unmanaged (and unregistered) investment company with a limited liIe.
The trust passes all dividends on the underlying securities to shareholders as
soon as practicable.
Securities lending and use oI derivatives are generally not practiced.

In the traditional mutual Iund structure, no market makers are involved in the creation
and redemption process.
When investors want to purchase the shares oI a Iund, the Iund manager will
issue new shares to the investors and take the cash to the capital markets to buy
securities that Iit the Iund's objective.
When investors want to sell the shares oI the Iund, the manager will sell securities
back to the capital markets, and use the cash raised to redeem shares Irom the
investors.

Unlike close-end Iunds, open-end and UIT ETFs use market makers in the unique
"in-kind" creation and redemption process.

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Creation and redemption units are created in large multiples oI individual ETF shares,
Ior example, 50,000 shares. These units are available to exchange specialists
(authori:ed participants or creation agents) that are authorized by the Iund and who
will generally act as market makers on the individual shares. The Iund publishes the
index tracking portIolio that it is willing to accept Ior in-kind transactions.

When there is excess demand Ior ETF shares, an authorized participant will
create a creation unit by depositing with the trustee oI the Iund the speciIied
portIolio oI stocks used to track the index. In return, the authorized participant
will receive ETF shares that can be sold to investors on the stock market. A
purchase order to buy ETF shares is not directed to the Iund but to the market
makers on the exchange. In contrast, in the traditional mutual Iund structure an
increase in demand Ior the shares oI the mutual Iund is met by the mutual Iund,
which simply issues new shares to the investor (and the Iund manager will take
the cash to the capital markets and buy securities appropriate to the Iund's
objective).

II there is an excess number oI ETF shares sold by investors, an authorized
participant will decide to redeem ETF shares by exchanging with the Iund a
redemption unit Ior a portIolio oI stocks held by the Iund and used to track the
index. As opposed to traditional open-end Iunds, this process means that no
capital gain will be realized in the Iund's portIolio on redemption. II the
redemption were in cash, the Iund would have to sell stocks and iI their price had
appreciated, the Iund would realize a capital gain and a tax burden Ior all existing
Iund shareholders. This is not the case with ETFs. Certainly individual ETF
shareholders can require in-cash redemption but the practice is discouraged:
A large Iee is charged on in-cash redemptions.
In-cash redemptions are based on the NAV computed several days aIter the
transactions, not the current NAV. As a result, investors will be reluctant to
redeem in cash because the redemption value is unknown at the time oI
redemption.
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ThereIore, it is more advantageous Ior them to sell their shares on the market
than to redeem them in cash.





g. discuss the advantages, disadvantages, and risks of E1Fs.

Advantages:
DiversiIication can be obtained easily with a single ETF transaction.
They trade similarly to a stock.
They trade throughout the whole trading day instead oI trading once a day, as do
the traditional open-ended mutual Iunds.
The management oI their risk is augmented by Iutures and options contracts on
them.
Transparency oI portIolio holdings.
Cost eIIective: no load Iees, low expense ratio since they are passively managed
and there is no shareholder accounting at the Iund level.
Avoidance oI signiIicant premiums or discounts to NAV because oI their unique
structure: arbitrage helps keep the traded price oI an ETF much more in line with
its underlying value. This is contrast to closed-end index Iunds, which oIIer a
Iixed supply oI shares, and as demand changes, they Irequently trade at
appreciable discounts Irom -- and sometimes premiums to -- their NAVs.
Tax savings Irom payment oI in-kind redemption.
Immediate dividend reinvestment Ior open-end ETFs.

Disadvantages:
Only a narrow-based market index tracked in some countries.
Intraday trading opportunity is not important Ior long-horizon investors.
Large bid-ask spreads on some ETFs. As a result, investing in these Iunds is very
costly.
Possibly better cost structures and tax advantages to direct index investing Ior
large institutions. Such a portIolio may also have lower taxes than an ETF.

The Iollowing risks do not aIIect all ETFs to the same extent.
Market risk: similar to those oI holders oI other diversiIied portIolios.
Asset class/sector risk: the returns Irom the type oI securities in which an ETF
invests may underperIorm returns Irom the general securities markets or diIIerent
asset classes.
Trading risk: bid-ask spread can be large Ior some ETFs with low trading
volumes. Trading prices oI some ETFs may diIIer markedly Irom their NAVs due
to the Iluctuations in the securities markets.
Tracking error risk: ETFs may not be able to exactly replicate the perIormance oI
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the indexes because oI Iund expenses and other Iactors.
Derivative risk: this aIIects only those Iunds that employ derivative in their
investment strategies. These derivatives may cause additional risk, such as
counterparty credit risk or high leverage.
Currencv risk and countrv risk: they apply to ETFs that are based on international
indexes. Currency risk is the risk oI capital loss due to unIavorable changes in
currency exchange rates. Country risk is the risk caused by economic and
political turbulences in diIIerent countries. In general emerging markets have
greater country risk than developed countries.





h. describe the forms of real estate investment.

In general, real estate reIers to buildings and buildable lands, including residential
homes, raw land, income-producing properties such as warehouses, oIIice and
apartment buildings. Real estate is a type oI tangible assets, which are investment
assets that can be seen and touched. In contrast, Iinancial assets are only recorded as
pieces oI paper.

There are several Iorms:

Free and Clear Equity. Also called fee simple, it reIers to Iull ownership rights
Ior an indeIinite period oI time, giving the owner the right, Ior example, to lease
the property to tenants and resell the property at will.

Leveraged Equity. It reIers to the same ownership rights but subject to debt
(such as a promissory note) and a pledge (mortgage) to hand over real estate
ownership rights iI the loan terms are not met.

Mortgages. They represent a type oI debt investment as a mortgage provides the
investor a stream oI bond like payments. This is a Iorm oI real estate investment
as the creditor may end up with owning the property being mortgaged. To
diversiIy risks a typical investor oIten invests in securities issued against a pool oI
mortgages.

Aggregation Vehicles. They aggregate investors and serve the purpose oI giving
investors collective access to real estate investments.
Real Estate Partnerships (RELPs). A RELP is a proIessionally managed
real estate syndicate that invests in various types oI real estate. The purpose
oI the RELP varies Irom raw land speculation to investments in income
producing properties. Managers assume the role oI general partner with
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unlimited liability, while other investors are treated like limited partners with
limited liability.
Commingled Funds. They are pools oI capital created largely by
like-minded institutional investors organized together by an intermediary to
invest chieIly in real estate investment projects. They can be either open or
closed end. For example, an open-ended commingled Iund does not have a
termination date, accepts new investors aIter initiation oI the Iund, and
amends the real estate portIolio over time.
Real Estate Investment Trusts (REITs). A REIT is a type oI closed-end
investment company that sells shares to investors and invests the proceeds in
various types oI real estate and real estate mortgages.
It allows small investors to receive both the capital appreciation and the
income returns without the headache oI property management.
Its shares are traded on a stock market.
It provides a tax shelter.
It also has strong restriction on the use, and distribution oI Iunds.





i. explain the characteristics of real estate as an investable asset class and describe
the various approaches used in the valuation of real estate.

Some characteristics oI real estate as an investable asset class:
Properties are immovable and basically indivisible so they are generally illiquid.
Every property is unique, primarily because no two properties can share the same
location. In addition, terms and conditions oI transactions may diIIer signiIicantly.
ThereIore properties are only approximately comparable to other properties.
There is no national, or international, auction market Ior properties. ThereIore it
is diIIicult to assess the market value oI a given property.
Transaction costs and management Iees Ior real estate investments are high.
Real estate markets suIIer ineIIiciencies because oI the nature oI real estate itselI
and because inIormation is not Ireely available.

Appraisal is the process Ior estimating the current market value oI a piece oI property.
Because oI both technical and inIormational shortcomings, this estimate is subject to
substantial error.

There are three commonly used approaches to real estate market value:

The Cost Approach: the real estate valuation approach based on the idea that an
investor should not pay more Ior a property than it would cost to rebuild it at
today's prices. It generally works well Ior new or relatively new buildings. Most
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experts use it as a check against a price estimate. Limitations:
an appraisal oI the land value is not always an easy task.
the market value oI an existing property could diIIer signiIicantly Irom its
construction cost.

The Sales Comparison Approach: this approach uses as the basic input the sales
prices oI properties (benchmark value) that are similar to the subject property.
The price must be adjusted to reIlect its superiority or inIeriority to comparable
properties. This approach can give a good Ieel Ior the market.

Hedonic Price Estimation:
IdentiIy the major characteristics (age, size, location, etc) oI a property that
can aIIect its value.
Give a quantitative rating Ior each characteristic.
PerIorm regression analysis oI sales price Ior all recent transactions in the
benchmarks on their characteristics ratings.
The estimated slope coeIIicients are the valuation oI each characteristic in the
transaction price. It is a benchmark monetary value associated with each
characteristic's rating.
It is then possible to estimate the selling price oI a speciIic property by taking
into account its rating on each Ieature.

The Income approach: this approach calculates a property's value as the present
value oI all its Iuture income. It assumes that the annual net operating income
(NOI) oI a property can be maintained at a constant level Iorever (that is, NOI is a
perpetuity). The most popular income approach is called direct capitalization:

market value (annual net operating income) / (market capitalization rate)

Net operating income (NOI) equals the amount leIt aIter subtracting
vacancy and collection losses and property operating expenses Irom an
income property's gross potential rental income.
The market capitalization rate is obtained by looking at recent market sales
Iigures to determine the rate oI return required by investors. Market Cap Rate
Benchmark NOI / Benchmark Transaction Price, where benchmark reIers
to a comparable property, or the median or mean oI several comparable
properties.
As long as inIlation can be passed through, it will not aIIect valuation,
because the market cap rate also incorporates the inIlation rate.

The Discounted AIter-Tax Cash Flow Approach: iI the investor can deduct
depreciation and any interest payments Irom NOI, then the investor's aIter-tax
cash Ilows depend on the investor's marginal tax rate.

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j. calculate the net operating income (AOI) from a real estate investment.

Here is a sample oI income statement oI a real estate property (an apartment
building):

0o:: utu' `uom 8 x 33 x !?) S3?,!b0
Out`u_ xu:::
|t`'`t`: S?,830
Tu:l o''t`ou b
lu`: uud mu`utuuu 00
lomot`ou uud udvt`:`u_ !0
loty `u:uuu 810
loty tux: 3,?00
::: Totu' out`u_ xu:: 8,!9
\t out`u_ `uom \OT) S?3,9b

This should give you a rough idea income and expense components oI a real estate
property.

Note that:
Depreciation expenses are not subtracted Irom gross rental income, as it is
assumed that repairs and maintenance will keep the property in good condition
Iorever.
Interest expenses are also not subtracted Irom gross rental income as this
approach is used to estimate the value oI the property independently oI how
the investment is Iinanced.





k. calculate the value of a property under the sales comparison and income
approaches.

Sally Hopper owned an apartment building in London that consisted oI 50 units and
60,000 square It. oI living area. The building had a 5 vacancy rate. Monthly rentals
averaged $4000 per unit with an average collection loss oI 1 per year (on gross
rental income). Annual property operating expenses averaged $1100 per month/per
unit whether it was rented or not. Insurance plus property taxes averaged another $600
per month/per unit. Sophie assumes that properties in her area earn at least 10 per
year based on recent sales Iigures. What is the value oI Sally's property using the NOI
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approach?

Solution:

Number oI Units 50
Monthly Rental 4000
Total Potential Rent (annual) 2,400,000
Vacancy Rate - 5 120,000
Collection Loss - 1 22,800
Operating Expenses 660,000
Property taxes insurance 360,000
Total Annual Adjustments & Expenses 1,162,800
NOI 1,237,200
Cap Rate .10
Market Value $12,372,000

Income Approach: The income approach uses a discounted cash Ilow approach oI
Iuture income. The most common approach oI this methodology is reIerred to as the
direct capitalization method.

The direct capitalization method presumes that the annual net operating income
continues as a perpetuity (inIinity), earning the investor his opportunity cost oI Iunds
or market capitalization rate. The net operating income Iormula is Iormula is:
Market Value Annual net operating income / Market capitalization rate
V NOI / R

Note: the collection loss is based on the amount oI accrued rent, not potential rent. In
this case, the accrued rent is $2,400,000 less the 5 vacancy oI $120,000. Thus the
collection loss (or bad debt) is $22,800 (($2,400,000 - $120,000) *.01).
The market capitalization rate examines recent market sales Iigures to determine the
rate oI return currently demanded by investors. For example, assuming a NOI oI
$1,237,200 and a market cap rate oI 10, the value oI the Iirm is $12,372,000 shown
below.

NOI $ 1,237,200
Market Capitalization Rate .10
V 1,237,200 / .10 $12,372,000

II there are numerous properties an appraiser may use an average oI NOI and the
market capitalization rates. Level I candidates should recognize that iI gross potential
income is provided, some operating expenses need to be subtracted in order to arrive
at the NOI Iigure.


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l. calculate the after-tax cash flows, net present value, and yield of a real estate
investment.

To move Irom NOI to aIter-tax cash Ilows we need to perIorm some calculations. The
Iollowing is the cash Ilow analysis Ior an apartment building Irom year 1999 to 2003:



!999 ?000 ?00! ?00? ?003
Tuom Tux Comutut`ou: Tuom Tux Comutut`ou: Tuom Tux Comutut`ou: Tuom Tux Comutut`ou:
\OT S??,8?? S?1,1!9 S?b,!?8 S?,9 S?9,9!1
Tut:t ?0,30 ?0,?9 ?0,!1b ?0,0?? !9,8
D`ut`ou b,1 b,1 b,1 b,1 b,1
Tuxu|' `uom'o::) 1,03 ?,38 b3 !,390 3,19?
Hu_`uu' tux ut 0.3! 0.3! 0.3! 0.3! 0.3!
Tux :uv`u_:) o
tux:)
!,?b3 39 ! 13! !,083
/t /t /t /t Tux Cu:l l'o /TCl) Comutut`ou: Tux Cu:l l'o /TCl) Comutut`ou: Tux Cu:l l'o /TCl) Comutut`ou: Tux Cu:l l'o /TCl) Comutut`ou:
\OT S??,8?? S?1,1!9 S?b,!?8 S?,9 S?9,9!1
Hot_u_ uymut ?!,?80 ?!,?80 ?!,?80 ?!,?80 ?!,?80
botux u:l 'o !,1? 3,!39 1,818 b,b 8,b31
Tux :uv`u_:) o
tux:)
!,?b3 39 ! 13! !083
/TCl ?,80 3,88 ,0?3 b,?1b ,!

In this case, potential tax savings accrue during the Iirst 3 years because the allowable
tax deductions oI interest and depreciation exceed the property's net operating income;
in the Iinal 2 years, income exceeds deductions, so taxes are due.

The "magic" oI simultaneously losing and making money is caused by depreciation.
Tax statutes incorporate this tax deduction, which is based on the original cost oI the
building to reIlect its declining economic liIe. However, because this deduction does
not require a current cash outIlow by the property owner, it acts as a non-cash
expenditure that reduces taxes and increases cash Ilow. Usually depreciation is
subtracted Irom NOI to compute aIter-tax net income, and is then added back to
reIlect its positive impact on aIter-tax cash Ilows. In other words, in the 1999 - 2001
period the property ownership provides the owner with a tax shelter. Also note that
mortgage payments have two components: interest payment which is tax deductible,
and principal repayment, which is no tax deductible.

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m. explain the various stages in venture capital investing.

Private equity reIers to equity investments that are not traded on exchanges.
Venture capital is Iinancing Ior privately held companies, typically in the Iorm oI
equity and/or long-term debt. Venture capital becomes available when Iinancing Irom
banks and public debt or equity markets is either unavailable or inappropriate. It is
one oI the main categories oI private equity. Investors typically invest in private
equity through limited partnerships, where the general partners are private equity
experts and manage the investments oI the venture capital Iunds.

Venture capital investing is done in many stages Irom seed through mezzanie. These
stages can be characterized by where they occur in the development oI the venture
itselI.

Seed-stage financing: this is capital (typically less than $50,000) that is provided
at the "idea" stage, which goes Ior product development and market research.

Early-stage financing is capital provided Ior companies moving into operation
and beIore commercial manuIacturing and sales have occurred.
Start-up: this capital is used in product development and initial marketing
Ior Iirms in business under one year and has not sold their product
commercially.
First-stage: this is capital provided to initiate commercial manuIacturing and
sales.

Formative-stage financing includes seed stage and early stage.

Later-stage financing is capital provided aIter commercial manuIacturing and
sales have begun but beIore any initial public oIIering.
Second-stage: this capital is used Ior initial expansion oI a company that has
already been selling a product but perhaps not yet proIitably.
Third-stage: capital provided to Iund major expansion, such as physical
plant expansion, product improvement, or a major marketing campaign.
Mezzanine (bridge) financing is capital provided to prepare Ior the step oI
going public and represents the bridge between the expanding company and
the IPO.

Expansion-stage financing includes second and third stage. Balanced-stage
financing is a term used to reIer to all the stages, seed through mezzanine.




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n. discuss venture capital investment characteristics and the challenges to venture
capital valuation and performance measurement.

Venture capital investment characteristics include:

Illiquidity: venture capital investments do not provide an easy or short-term path
Ior cashing out. Liquidation or divestment oI each venture within a portIolio is
dependent on the success oI the Iund manager in creating a buy-out or IPO
opportunity. Venture capitalists expect to actually realize their returns only when
they are able to cash out, which hopeIully is less than ten years, and preIerably in
three to seven.

Long-term commitment required: this is due to the time lag to liquidity. II the
average investor is averse to illiquidity, this will create a liquidity risk premium
on venture capital. This is why an investor with longer than average time horizon
(i.e. university endowments) can expect to proIit Irom this premium.

DiIIiculty in determining current market values: this is because there is no
continuous trading oI the investments within a venture Iund portIolio.

Limited historical risk and return data: this makes it diIIicult to estimate risks.

Limited inIormation: it's thereIore diIIicult to estimate cash Ilows or the
probability oI success oI these ventures.

Entrepreneurial/management mismatches: entrepreneurs may not be good
managers although Iund managers rely on entrepreneurs to create value.
Particularly, entrepreneurs who can run small ventures successIully may not have
the ability to manager larger companies. Entrepreneurs may not have the
incentive to work in the best interest oI the Iund managers. For example,
entrepreneurs may be more interested in turning their Iavorite idea into reality,
whereas Iund managers are interested in the Iinancial success oI the ventures.

Fund manager incentive mismatches: it is the investors, not the Iund managers,
who contribute the capital. Fund managers may be rewarded by size oI their Iund
rather than perIormance oI their Iund. Investors should motivate Iund managers
to make sure an aligned interest together.

Lack oI knowledge oI how many competitors exist: as entrepreneurs operate in
uncharted territory, there is oIten little way Ior analysts to perIorm competitive
analysis (i.e. how many other entrepreneurs are developing substitute ideas or
products at the same time).

Vintage cycles: some years are better than others. For example, iI too many
Study Session 18 Alternative Investments
CFACENTER.COM 17
investors are willing to supply Iund Ior venture capital, many entrepreneurs with
mediocre ideas or products will get Iinancing easily, thereby depressing the
returns on venture capital. This may happen particularly iI there is a strong IPO
market and/or a perception that a promising new technology can generate
valuable investment opportunities.
Poor Iinancial market conditions can cause venture capital to dry up.
PerIormance by vintage year oIten varies signiIicantly due to diIIerences in
the perIormance oI both real and Iinancial markets over the liIe oI the Iund.
Historically, venture Iunds Iormed in high growth years Ior the industry
experience lower returns. The venture capital market is subject to supply and
demand.

Extensive operations analysis and advice may be required: more than Iinancial
engineering skill is required oI Iund managers. The venture capital manager must
be able to act as both a Iinancial and an operations management consultant to the
venture.

Valuing a prospective venture capital project is challenging:
It's diIIicult to estimate Iuture cash Ilows. There are simply too many signiIicant
uncertainties.
Many projects will Iail along the way to IPO. Those who can provide the
anticipated large payoII at the time oI exit are really Iew. Even iI the ventures
eventually succeed, the investment horizon is long and uncertain.
Some oI the unique risks come Irom their investment characteristics as described
above.

The risk oI a portIolio oI venture capital investments is less than the risk oI any
individual venture project because oI risk diversiIication.

There are also several challenges to perIormance measurement:
The diIIiculty in determining precise valuations. This is mainly because their
investments are not publicly traded and thus their current market values are
typically estimated using arbitrary techniques.
The lack oI meaningIul benchmarks against which Iund manager and investment
success can be measured.
The long-term nature (probably a number oI years aIter the initial investments) oI
any reliable perIormance Ieedback in the venture capital asset class.





o. calculate the net present value (APJ) of a venture capital project given the
project's possible payoff and conditional failure probabilities.
Study Session 18 Alternative Investments
CFACENTER.COM 18

The expected net present value oI a venture capital project with a single, terminal
payoII and a single, initial investment can be calculated, given its possible payoII and
its conditional Iailure probabilities, as the present value oI the expected payoII minus
the required initial investment.





p. discuss the descriptive accuracy of the term "hedge fund" and define hedge fund
in terms of objectives, legal structure, and fee structure.

To "Hedge", according to Webster's dictionary, is "a means oI protection or deIense
(as against Iinancial loss), or to minimize the risk oI a bet". The term "hedge Iund"
includes a multitude oI skill-based investment strategies with a broad range oI risk
and return objectives. A common element is the use oI investment and risk
management skills to seek positive returns regardless oI market direction.

A hedge Iund is a private "pool" oI capital Ior accredited investors only and organized
using the limited partnership legal structure. The general partner is usually the money
manager and is likely to have a very high percentage oI his/her own net worth
invested in the Iund.

The Iund has an oIIering memorandum which is intended to provide much oI the
necessary inIormation to support an investor's due diligence. Among several topics,
the oIIering memorandum will speciIy the trading style, hedging strategies, and
instruments to be employed by the Iund at the discretion oI the general partner (i.e.
being long and /or short stock; use oI puts, calls, and Iutures; use oI OTC derivatives).

Hedge Iunds utilize alternative investment strategies Ior the purpose oI achieving
superior returns relative to risk (i.e. return vs. standard deviation). PerIormance
objectives range Irom conservative to aggressive. The degree oI hedging varies. In
Iact, some do not hedge at all while others simply use S&P put options and Iutures in
lieu oI shorting equities. Consequently, there is a broad spectrum oI expected risk and
return within the hedge Iund universe.

The term hedge fund is not Iully descriptive because the hedged position is generally
designed to isolate a bet rather than to reduce risk. Hedge Iunds can be deIined as:

Iunds that seek absolute returns in all directions: hedge Iund managers seek
Ireedom to achieve high absolute returns (that is, alpha) and wish to be rewarded
Ior their perIormance. In contrast, the money management industry has moved
toward a Iocus on perIormance relative to pre-speciIied benchmarks (e.g. a
Study Session 18 Alternative Investments
CFACENTER.COM 19
market index).

Iunds that have a legal structure avoiding some government regulations: these
legal structures allow the Iund manager to take short and long positions in any
asset, to use all kinds oI derivatives, and to leverage the Iund without restrictions.
In the US hedge Iunds most oIten take the Iorm oI limited partnership. For
example, organized under section 3(c)(1) oI the Investment Company Act, a
Iund is limited to no more than 1,009 "accredited investors", and is
prohibited Irom advertising.
Offshore funds are incorporated in locations such as the British Virgin
Islands or other locations attractive Iro a Iiscal and legal point oI view.

Iunds that have option-like Iees: this includes:
a base management fee: based on the value oI assets under management. It
is paid whatever the perIormance oI the Iund. It is typically 1 percent oI the
asset base.
an incentive fee: it is proportional to realized proIits. It is typically 20
percent oI the total proIits. For some Iunds, the incentive Iee is applied to
proIits above a pre-speciIied risk-Iree rate. For example, suppose the
pre-speciIied risk-Iree rate is 6. II the gross return on the Iund is 5.5, then
no incentive Iee will be paid. The incentive Iee cannot Iall below zero, even
iI the return on the Iund is negative.

Finally, let's take a look at the key diIIerences between mutual Iunds and hedge Iunds:

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Study Session 18 Alternative Investments
CFACENTER.COM 20
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q. calculate the net return of a hedge fund, given an absolute return scenario and
the fund's fee structure.

The net perIormance oI a hedge Iund can be calculated by subtracting its Iees Irom its
gross perIormance.

Example (taken Irom the textbook)
Study Session 18 Alternative Investments
CFACENTER.COM 21

A hedge Iund has an annual Iee oI 1 percent base management Iee plus a 20 percent
incentive Iee applied to proIits above the risk-Iree rate, taken to be the T-Bill rate.
Hence the incentive Iee is applied to annual proIits aIter deduction oI the T-Bill rate
applied to the amount oI assets under management at the start oI the year. The gross
return during the year is 40. What is the net return (the return aIter Iees) Ior an
investor, iI the risk-Iree rate is 5 percent?

Solution

Fee 1 20 x (40 - 5) 8.
Net return: 40 - 8 32.





r. describe the various classifications of hedge funds.

Hedge Iunds can be classiIied in a variety oI ways. Here is one classiIication (by
investment strategy):

Long/short funds: Funds employing long/short strategies generally invest in
equity and Iixed income securities taking directional bets on either an individual
security, sector or country level.
For example, a Iund might do pairs trading, and buy stocks that they think
will move up and sell stocks they think will move down. Or go long sectors
they think will go up and short countries they think will go down.
Long/Short strategies are not automatically market neutral. That is, a
long/short strategy can have signiIicant correlation with traditional markets,
and surprisingly have seen large down turns in exactly the same times as
major market downturns.
Long/short Iunds represent a large amount oI hedge Iund assets.

Market-neutral funds: They are a Iorm oI long/short Iunds that attempt to be
hedged against a general market movement. They attempt to produce return series
that have no or low correlation with traditional markets such as the US equity or
Iixed income markets. Market neutral strategies are characterized less by what
they invest in than by the nature oI the returns. They oIten are highly quantitative
in their portIolio construction process, and market themselves as an investment
that can improve the overall risk/return structure oI a portIolio oI investments.
The key Ieature oI market neutral Iunds is the low correlation between their
returns and the traditional asset's.

Study Session 18 Alternative Investments
CFACENTER.COM 22
Global macro funds take bets on the direction oI a market, a currency, an interest
rate, a commodity, or any macroeconomic variable.
There are many subgroups in this category, including Iutures Iunds (or
managed Iutures Iunds) and emerging-market Iunds.
These Iunds seek to take advantage oI shiIts and stresses in global Iinancial
markets that impact currencies, crude oil, interest rates and stock indices.
For example, George Soros oI the Quantum Iund took a billion dollar proIit
Irom his historic bet against sterling and the Bank oI England in September
1992.
Leverage is the liIeblood oI global macro hedge Iunds. Global macro
investing, not surprisingly, has acquired a reputation as a high risk, high
return and extremely volatile investment strategy.

Event-driven funds seek to make proIitable investments by investing in a timely
manner in securities that are presently aIIected by particular events. Such events
include:
distressed debt investing: the securities oI companies having Iinancial
problems usually sell at deeply discounted prices. Distressed securities Iunds
take bets on the debt and/or equity securities oI such companies. For example,
iI a Iund manager believes such a company will successIully return to
proIitability, he will buy its securities. II he believes the company's situation
will deteriorate, he will take a short position in its securities.
merger arbitrage (sometimes called risk arbitrage): beIore the eIIective
date oI a merger, the stock oI the acquired Iirm typically sells at a discount to
its announced acquisition value. A risk arbitrage involves buying stocks oI
the acquired Iirm and simultaneously selling the stocks oI the acquirer.
However, there is the risk that the merger may Iall though.
corporate spin-offs and restructuring.





s. discuss the benefits and drawbacks to fund of funds investing.

Funds oI Iunds(FOF) have been created to allow easier access to small investors. An
FOF is open to investors and, in turn, invests in a selection oI hedge Iunds. An FOF
provides investors with several beneIits:
Retailing: investing in a single hedge Iund typically requires at least $100,000.
An FOF allows small investors to get exposure to a large selection oI hedge
Iunds.
Access: many attractive hedge Iunds are closed to individual investors because
the maximum number oI investors has been reached. Through an FOF, investors
can still get access to these Iunds that are closed to new investors.
Study Session 18 Alternative Investments
CFACENTER.COM 23
Diversification: an FOF allows investors to diversiIy the risk oI a single hedge
Iund.
Managerial expertise: not every investor has the skills to invest in hedge Iunds.
The manager oI the FOF is supposed to have expertise in Iinding reliable and
good-quality hedge Iunds in a world where inIormation on the investment
strategies oI hedge Iunds is diIIicult to obtain.
Due diligence process: the due diligence (both at the outset and ongoing) that has
to be perIormed by an institutional investor when selecting a hedge Iund is highly
specialized and time consuming, given the secretive nature oI hedge Iunds and
their complex investment strategies.

There are drawbacks with an FOF:
Fee: the obvious drawback oI FOFs is the Iees (the added layer oI Iees) they
charge on top oI the substantial Iees charged by the hedge Iunds they invest in.
Never one to be dismayed, Ineichen tells us this is like "Paying the Iarmer as well
as the milk man.".
Performance: The FOF typically selects individual hedge Iunds based on their
past experience. However, there is little evidence oI persistent perIormance as
past perIormance gives little implication oI Iuture perIormance.
Diversification: it is a two-edged sword. The overall FOF expected return will be
lowered by the diversiIication but the Iees paid are still very high.

What does Due Diligence mean?
An investigation or audit oI a potential investment. Due diligence serves to
conIirm all material Iacts in regards to a sale.
Generally, due diligence reIers to the care a reasonable person should take beIore
entering in an agreement or transaction with another party.
OIIers to purchase an asset are usually made dependent upon the results oI due
diligence analysis. It includes reviewing all Iinancial records plus anything else
deemed material to the sale. Sellers could also perIorm a due diligence analysis
on the buyer. Items that could be considered are the buyer's ability to purchase, as
well as other items that would aIIect the purchased entity or the seller, aIter the
sale has been completed.
Due diligence is essentially a way oI preventing unnecessary harm to either party,
or the entity involved, in a transaction.





t. discuss the leverage and unique risks of hedge funds.

Although some hedge Iunds don't use leverage at all, most oI them do. Leverage in
hedge Iunds oIten runs Irom 2:1 to 10:1, depending on the type oI assets held and
Study Session 18 Alternative Investments
CFACENTER.COM 24
strategies used. High leverage is oIten part oI the trading strategy and is an essential
part oI some strategies in which the arbitrage return is so small that leverage is needed
to ampliIy the proIit. As in any other investments, however, leverage also ampliIies
losses when the market direction turns out to be unIavorable. Hedge Iunds typically
use three methods to create leverage:
Borrowing external Iunds.
Borrowing through a brokerage margin account.
Using Iinancial instruments and derivatives that requires posting margins. By
using margins, hedge Iunds only pay a Iraction oI the value oI the position.

In addition to market and trading risks in diIIerent markets, hedge Iunds Iace the
Iollowing unique risks:

liquidity risk: the lack oI liquidity under extreme market conditions can cause
irreversible damage to hedge Iunds whose strategies rely on the presence oI
liquidity in speciIic markets.

pricing risk: hedge Iunds oIten invest in complex securities traded
over-the-counter. Pricing securities that trade inIrequently is a diIIicult task,
especially in periods oI high volatility.

counterparty credit risk: this is the risk that the other party to an agreement will
deIault. Because hedge Iunds deal with broker-dealers in most transactions,
counterparty credit risk can arise Irom many resources.

settlement risk: this risk reIers to the Iailure to deliver the speciIied security or
money by one oI the parties to the transaction on the settlement day.

short squeeze risk: a short squeeze arises when short sellers must buy in their
positions at rising prices. Because some hedge Iund strategies require short
selling, this risk can aIIect Iund perIormance signiIicantly.

financing squeeze risk: iI a hedge Iund has reached or is near its borrowing
capacity, its ability to borrow cash is constrained. This risk puts the hedge Iund in
a vulnerable position when it is Iorced to reduce the levered positions, say, in an
illiquid market at substantial losses.





u. discuss the performance of hedge funds and the biases present in hedge fund
performance measurement.

Study Session 18 Alternative Investments
CFACENTER.COM 25
In terms oI perIormance, hedge Iunds are generally viewed as having
Net returns higher than those available Ior equity or bond investments.
Lower risk than traditional equity investments. Note the risk is measured by
the volatility oI return.
A Sharpe ratio that is comparable to bonds and higher than that oI equity
investments.
A low correlation with conventional investments.

The perIormance data Irom hedge Iund databases and indexes suIIer Irom serious
biases.

Self-selection bias: hedge Iund managers decide themselves whether they want
to be included in a database, and managers that have Iunds with an unimpressive
track record will not wish to be included.

Instant history bias: as only hedge Iunds with good track records enter the
database, this creates a positive bias in past perIormance in the database.

Survivorship bias on return: As unsuccessIul Iunds tend to disappear over time,
only successIul ones search Ior new clients and present their track record. This is
particularly true Ior hedge Iunds, since they do not have to adhere to perIormance
presentation standards. As underperIorming Iunds disappear Irom the database
used by investors to select Iunds, the reported average return oI hedge Iunds is
inIlated.

Survivorship bias on risk: A similar survivorship bias applies to risk measures.
Hedge Iunds that exhibited highly volatile returns in the past tend to disappear.
Reported volatility oI existing Iunds will tend to be low.

Smoothed pricing on infrequently traded assets: Some assets trade
inIrequently. Hedge Iunds oIten use illiquid exchange-traded securities or OTC
instruments. Because prices used are oIten not up-to-date market prices, but
estimates oI Iair value, their volatility is reduced (smoothing eIIect).

Option-like investment strategies: Traditional risk measures used in
perIormance appraisal assume that portIolio returns are drawn Irom normal or at
least symmetric distributions. Many investment strategies Iollowed by hedge
Iunds have some option-like Ieatures that violate these distributional assumptions.
Instead they have asymmetric return distributions: iI the market moves in the
Iavorable direction, the pay-oII will generally be small. II the market moves in
the unIavorable direction, the loss can be enormous. ThereIore, traditional risk
measures understate the risk oI losses oI investment strategies Iollowed by hedge
Iunds.

Study Session 18 Alternative Investments
CFACENTER.COM 26
Fee structure and gaming: The compensation structure is option like and it
encourages excessive risk taking. Fund managers are paid to take risks. For
example, iI the total return on a hedge Iund is positive, the manager charges an
incentive Iee oI 20 oI the total return. II it's negative, however, the incentive Iee
will not Iall below zero. ThereIore, Iund managers are encouraged to take
excessive risks, particularly iI their recent perIormance is poor..





v. explain the effect of survivorship bias on the reported return and risk measures
for a hedge fund data base.

See los u please.






w. explain how the legal environment affects the valuation of closely held
companies.

Closely held companies are those that are not publicly traded. Inactively traded
securities are securities oI companies that are not traded Irequently. Such securities
generally do not trade on major exchanges such as NYSE.

Closely held companies may be organized in various legal Iorms, such as partnerships
and sole proprietorships. These Iorms have tax implications as well as ownership
diIIerences Ior the investor. Ownership is a bundle oI rights and these rights diIIer
depending on the business Iorm. Because valuations can be required to provide
evidence in litigation -- Ior example, minority shareholder claims -- much case law
deIines terms such as intrinsic value, Iundamental value, and Iair value. These
deIinitions may vary in diIIerent jurisdictions. Even what is judged as evidence Ior a
valuation can vary. There has long been a tension between the theory oI value as
based on projected cash Ilows and the acceptance oI the hard evidence oI recent cash
Ilows. In a real sense, then, valuation oI closely held and inactively traded securities
requires extensive knowledge oI the law and the purposes oI the valuation.





Study Session 18 Alternative Investments
CFACENTER.COM 27
x. describe alternative valuation methods for closely held companies and
distinguish among the bases for the discounts and premiums for these companies.

Here are the basic types oI valuation:

The Cost Approach: it attempts to determine what it would cost to replace the
company's assets in their present Iorm.

The Comparables Approach: it estimates market value relative to a benchmark
value. The benchmark value may be the market price oI a similar but actively
traded company. The estimate needs to be adjusted Ior changing market
conditions, the possibility that the benchmark itselI is mispriced, and the unique
Ieatures oI the company relative to the benchmark.

The Income Approach: it estimates market value by discounting any anticipated
Iuture economic income streams.

To estimate the discounts and premiums an analyst must careIully deIine the amount
or base to which the discount or premium should be applied.

As shares oI closely held companies lack a public market (lack marketability) and
so their valuation should reIlect a marketability discount. To estimate this the
analyst identiIies a publicly traded comparable company with a liquid market.
The comparable's market value oI equity is the base to which the marketability
discount is applied.

A minority discount is applied iI the interest will not be able to inIluence
corporate strategy and other business decisions. To estimate it the base is an
estimate oI that company's value oI equity inclusive oI the value arising Irom
ownership oI all rights oI control.

To estimate a control premium, the base is an estimate oI that company's value
oI equity not reIlecting control (the value oI equity Irom a minority shareholder
perspective).






y. discuss distressed securities investing and the similarities between venture capital
investing and distressed securities investing.

Distressed securities are securities oI companies that have Iiled or are close to Iiling
Study Session 18 Alternative Investments
CFACENTER.COM 28
Ior bankruptcy, or that seeking out-oI-court debt restructuring to avoid bankruptcy.
Valuation oI such securities requires legal, operational and Iinancial analysis.

Investing in distressed securities usually means investing in distressed company bonds
with a view toward equity ownership in the eventually reconstituted company. In this
regard such investments have characteristics somewhat similar to those oI venture
capital investing.
illiquid nature.
requires a long investment horizon.
requires intense investor participation in guiding the venture to a successIul
outcome.
possibility oI mispricing. In Iact, due to business volatility and high leverage,
mispricing in distressed securities is inevitable.

Distressed-security investing may be viewed as the ultimate in value investing. The
primary question is the question oI the distress source. For example, is the company
weak Iinancially or operationally? Distressed-security investing requires intense
industry analysis, as well as analysis oI business strategies and oI the management
team that will conduct the restructuring.





z. explain the role of commodities as a vehicle for investing in production and
consumption and identify the ways to indirectly invest in commodities.

There are three major categories oI commodities:
Agricultural products (oIten called soft commodities) include grains, Iibers,
Iood and livestock, etc.
Energy includes crude oil, heating oil and natural gas, etc.
Metals include copper, gold, and silver etc.

Investing directly in agricultural products and other commodities gives the investor a
share in the commodity components oI the country's production and consumption.
Commodities complement the investment opportunities oIIered by shares oI
corporation that extensively use these raw materials in their production processes.
However, most investors do not want to get involved in storing commodities such as
cattle or crude oil. A common investment objective is to purchase indirectly those real
assets that should provide a good hedge against inIlation risk. Commodity derivatives
are Iinancial instruments that derive their value Irom the value oI the underlying
commodities.
Futures contracts. This is the most common strategy. Commodity trading advisers
(CTAs) oIIer managed futures funds that take positions in exchange-traded
Study Session 18 Alternative Investments
CFACENTER.COM 29
derivative on commodities and Iinancials.
Bonds indexed on some commodity price.
Stocks oI companies producing the commodity.





aa. describe the motivation for investing in commodities and commodities
derivatives by both passive and active investors.
Commodities are sometimes treated as an asset class because they represent a direct
participation in the real economy. The motivation Ior investing in commodities ranges
Irom the diversiIication beneIits by a passive investor to the speculative proIits sought
by an active investor.

Commodities have a negative correlation with stock and bond returns and a
desirable correlation with inIlation. A passive investor would buy commodities
Ior their risk-diversiIication beneIits. When inIlation accelerates, commodity
prices go up, whereas bond and stock prices tend to go down. A passive investor
would typically invest through a collateralized position in a Iutures contract. A
collateralized position in Iutures is a portIolio in which an investor takes a long
position in Iutures Ior a given amount oI underlying value and simultaneously
invests the same amount in government securities such as T-bills.

In periods oI rapid economic growth, commodities are in strong demand to satisIy
production need, and their prices go up. Because oI productivity gains, the prices
oI Iinished goods are unlikely to rise as Iast as those oI raw materials. This
suggests an active management strategy in which speciIic commodities are
bought and sold at various times.

An example oI collateralized Iutures:

Assume that the Iutures price is currently $100. II $100 million is added to the Iund,
the manager will take a long position in the Iutures contract Ior $100 million oI
underlying value and simultaneously buy $100 million worth oI T-bills (part oI this
will be deposited as margin). II the Iutures price drops to $95 the next day, the
manager will have to sell $5 million oI the T-bills to cover the loss (marked to market).
Conversely, iI the Iutures price rise to $105, the manager will receive a proIit oI $5
million. The total return on the collateralized Iutures position comes Irom the change
in Iutures price and the interest income on the T-bills.




Study Session 18 Alternative Investments
CFACENTER.COM 30

bb. explain the sources of return on a collateralized commodity futures position.

See los aa please.





cc. explain how to manage risk for managed futures.

Jaeger (2002) proposes several principles Ior the risk management oI managed
Iutures portIolios:
DiversiIy into a large universe oI contracts.
Liquidity monitoring, because diversiIication into a larger universe oI
contracts can include illiquid contracts.
Volatility dependent allocation where the weight oI the diIIerent contracts in
the portIolio is determined by their historical or implied volatility.
Quantitative risk management techniques such as value at risk (VaR) and
stress tests.
Risk budgeting on various aggregation levels to detect undesired risk
concentrations.
Limits on leverage.
Use oI derivatives to hedge any unwanted currency risk.
Care in model selection with respect to data mining, in and out oI sample
perIormance, and adequate perIormance adjustments Ior risks.






dd. describe the motivation for investing in commodity linked securities.

Commodity-linked securities are securities that are indexed on some commodity
prices. The return on commodity-linked securities has two components: the increase
in commodity prices and the income on the securities. In contrast, holding
commodities provides no income so the sole return to the owner is through price
increase. ThereIore, investors who wish to have some income stream on their
investments may preIer to invest in commodity-linked securities.

There are two major types oI commodity-linked securities:

Commodity-linked bonds: interest payments and/or principal repayments oI
Study Session 18 Alternative Investments
CFACENTER.COM 31
such bonds are indexed to the price oI the underlying commodities or an
inIlation index. For example, a company may issue bonds indexed to oil
prices.

Commodity-linked equity: the equity value oI some companies is directly
aIIected by commodity prices. This is particularly true Ior energy companies,
such as those in oil and gas industries. As large companies tend to diversiIy
across diIIerent types oI activities within the industries, the link between
prices and stock prices Ior large companies is typically weaker than that Ior
small undiversiIied companies.