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Crash Course for Alternative Investment CFA Level-I Exam

Alternative Investment

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Neev Knowledge Management Pristine

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Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds Commodities

Lower liquidity than traditional investments. Difficult to determine fair market values. Limited historical performance data available

Advantages allows to invest in hedge fund with limited capital HNI can diversify their investments by taking small exposure to large no. of hedge funds through fund of funds manager will have expertise in selection of large no. of good hedge funds and expertise to do the necessary due diligence

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fund of funds charge mgmt fee in addition to mgmt fees charged by hedge fund diversification will reduce the investors risk but at the cost of returns fund manager may or may not outperform the single hedge fund

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds Commodities

Open End Fund Corpus changes Purchases, Redemptions at NAV Closed End Fund Corpus Fixed MF Units traded on exchanges

NAV = Fund AssetsLiabilities

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Types of Fees Load charges front-end back-end Components of Expense Ratio Fund Management Charge (FMC) Administrative fees Continuing distribution fees referred to 12b-1 fees in the USA

Types of Funds Style Value/Growth Large cap/Midcap Sector Banking, Energy Index S&P 500, DJIA International Excludes home country Global Includes home country Stable value Short term govt. sec. Guaranteed Guaranteed rate of return

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds Commodities

Special type of fund that invests in a portfolio of stocks or bonds; designed to replicate performance of a specified index.

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Advantages of ETFs Efficient method of diversification. Trade similar to traditional equity investments. Some ETFs patterned after indexes with active futures/option market; better risk mgmt. Exact composition is known at all times. Typically, very efficient operating expense ratios; no loads to purchase or redeem shares. Decreased capital. gains tax liability.

Disadvantages of ETFs Some countries have fewer indexes than U.S. for ETFs to track, results into mid-cap or small-cap stocks not being well represented. Ability to trade intraday may not be significant to investors with longer time horizons. ETFs with low trading volume may have large bid-ask spreads. Larger investors may choose to directly invest in an index portfolio, resulting in lower expenses / lower tax consequences .

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds Commodities

Valuation methods: Cost method, sales comparison method & income method Income method uses a discounted cash flow model similar to that for a perpetuity: Value =NOI / Market cap rate

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Net operating income (NOI) equals gross operating income less estimated vacancy. collections. & other operating expenses, (including property taxes, but excluding income taxes). NOI does not include depreciation or financing costs

Q. Calculate the NOI. The information is as follows:

Rental Income Vacancy rate Insurance Taxes Utilities Maintenance $300,000 5% $12,000 $8,000 $7,000 $18,000

Ans. NOI = 300,000 *(1-0.05) 12,000 8,000 7,000 18,000 = $248000

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds

Types of Hedge Funds

Risk

Hedge Fund Biases

Commodities

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Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds

Commodities

Long / short funds: largest among them in terms of asset base. Take long / short positions on common stocks

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Market neutral funds: type of long / short fund in which long & short positions will make the net exposure to market equal to zero

Global macro funds: funds that bet on the direction of a macroeconomic factors like currency, interest rates or direction of market etc.

Event driven funds: make use of opportunities like turnaround of distressed company, potential merger available in the market

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds

Risk

Commodities

Liquidity

Potential for mispricing

Settlement errors

Counterparty credit risk

Short covering

Margin calls

Investments in esoteric, infrequently traded securities may lead to difficulty in determining the true value.

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Risk of counterparty: failure to deliver security on settlement day as agreed upon.

Can result in forced selling of assets, possibly at a loss, on an already highly leveraged position.

Risk that managers have to cover their shorts & repurchase securities at price higher than where they originally sold.

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds

Hedge Fund Biases Commodities

Self selection bias: fund manager may not disclose his poor performance and may include only successful track records

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Back filling bias: fund managers with poor performance may not participate in hedge fund index, which leads to overestimated performance of hedge fund industry

Survivorship bias: only best performing hedge funds survive in this industry and thus only funds with successful track records are likely to be included in calculating index

Option like strategies: some of the option strategies may have asymmetric payoff which may not be fully reflected by standard deviation or Value at risk

Smoothed pricing of infrequently traded assets: some of the assets are not widely traded in the market and marked to market with the help of broker or dealer. These values estimated by dealers are more stable over the time and reduces reported volatility of fund

Fee structure & gaming: fee structure is designed in a such a way that manager is paid small fixed amount & large variable component based on the performance of fund. It may compel managers to take a big bets in order to get higher remuneration

Alternative Investment

Characteristics

Fund of Funds

Mutual Funds

Exchange Traded Funds (ETF)

Valuation of Real Estate Investments

Hedge Funds

Commodities

Contango Future Price > Spot Price Backwardation Future Price< Spot Price

Roll Yield This files has expired at 30-Jun-13 Contango Negative Yield Roll Backwardation Positive Yield Roll

When treasuries are pledged as collateral for a commodities futures trade, the yield on the treasuries is called collateral yield.

Unlike equity index funds, the commodity index strategies are ACTIVE since future contracts need to be rolled.

Question 1
An investor wishes to invest in Becker fund Ltd and the details are given as below: Land : 2,000,000 Investments : 75,000,000 Liabilities : 17,000,000 Accrued Expenses: 500,000 Front end load: 2% Outstanding units : 1,000,000 This files has expired at 30-Jun-13 Calculate NAV A. 59.5 B. 60 C. 58.31

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Answer 1
A. The formula for calculating NAV is (Assets-Liabilities-Accrued expenses)/Outstanding units = (2m+75m-17m-0.5m)/1m= 59.5 Hence A is correct. The information on front end load is not required to calculate NAV.

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Question 2
A UK Global macro fund manager wants to invest his funds. Which of the following scenarios are least likely suitable for him for investing purposes?

A. Steep fall in the US dollar. B. An aquisition of a distressed firm by another foreign company on expectations of synergy benefits. C. Low volatility in the Japanese stock markets.

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Answer 2
B. An event driven fund manager would be looking for investment in the distressed firm's acquisition.

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Question 3
What is the most likely motive of creating a collateralized commodities futures position? A. To earn a return equal to gain on futures position plus the interest on treasury securities like T bills. B. To buy more T bills, when the futures contract prices fall. C. To sell more T bills, when the futures contract prices fall.

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Answer 3
C. A collateralised commodities futures position is created by going long on commodities futures and buying treasury securities worth the contract value of the futures contract. If futures fall, it results in margin calls as long on futures loses, which can be honoured by selling T bills, hence C is correct. B is incorrect as T bills are bought when futures prices increase as investor is long.

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Question 4
Which of the following conclusions regarding hedge funds is least likely to be correct? A. Hedge funds have higher risk profile than equity investments measured by standard deviation B. Sharpe ratio for hedge funds has been consistently higher than most equity investments C. There is low correlation between hedge fund performance and conventional asset class

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Answer 4
A. The correct answer is Hedge funds have higher risk profile than equity investments measured by standard deviation

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Question 5
Which of these are not the risks involved in ETFs? A. High liquidity may lead to larger bid ask spreads in ETF prices. B. Some ETFs resort to taking positions in options and forward markets for hedging purposes, leading to credit risks. C. An investor is exposed to country and currency risks for investing in international ETFs.

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Answer 5
A. Low liquidity may lead to larger bid ask spreads in ETF prices. OTC derivatives like forwards and options involve counterparty/credit risks.

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Question 6
The limitation in which the disclosure of past performance of all the funds managed vests with the fund manager is termed as:

A. Back-filling bias B. Survivorship bias C. Self-selection Bias

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Answer 6
C. When the index only includes surviving funds and not the discontinued ones, its called survivorship bias. Hence B is incorrect. Hedge fund index includes mostly those managers who have strong track record is called back-filled bias. Hence A is incorrect. However the funds to be disclosed voluntarily at the discretion of the fund manager leads to Self-selection bias, hence C is correct.

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Question 7
An investor is considering the purchase of a commercial real estate and provided following information: Gross potential rental income 175,000 Vacancy & collection loss rate 8% Insurance 15,000 Taxes 12,000 Utilities and maintenance 25,000 Calculate the appraisal value of the property if market cap rate is 10%? This files has expired at 30-Jun-13 A. 1,210,000 B. 1,090,000 C. 1,230,000

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Answer 7
B. The correct answer is 1,090,000 NOI= 175000*(1-8%)- 25000 15000- 12000= 109,000 Appraisal value= 109,000/10%= 1090,000

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Question 8
In which of the following types of hedge funds, fund invests in a distressed company or in a potential merger & acquisition situation? A. Long / short funds B. Event driven funds C. Market neutral funds

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Answer 8
B. The correct answer is Event driven funds

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