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CFA LEVEL 1 

 
STUDY SESSION 18 
 
ALTERNATIVE
INVESTMENTS

Copyright (2014), CFA Institute.

Reproduced and republished with permission from CFA Institute. All rights reserved
Less liquidity of assets held

More specialization by investment managers

a. Compared to
Less regulation and transparency
traditional
investments, AI a
exhibit: More problematic and less available historical
return and volatility data

Different legal issues and tax treatments

employ a large number of


different strategies
HFs may use leverage, derivatives,
long & short positions
invest in illiquid assets

absolute basis
HF return objectives
relative basis

Limited partnership
Limited partner (LP)
Legal structure .--->
General partner (GP)
Basic
Less regulated

< traditional, publicly traded investments


Liquidity Restrictions on redemptions lockup period
may include AND/OR notice period

Diversification
Allowing smaller investors to
Advantages access HFs
Fund of funds maybe able to negotiate
better redemption terms
60.1.
Alternative Disadvantages Double fees
Investments
Merger arbitrage
1. Event-driven Distressed/restructuring
strategies Activist shareholder
Special situations
b,d,e.
Convertible arbitrage fixed income
HEDGE
FUNDS Asset-backed fixed income
2. Relative value
General fixed income
Strategies strategies
Volatility
Multi-strategy
3. Macro strategies
Market neutral
Fundamental growth
4. Equity hedge
Fundamental value
fund strategies
Quantitative directional
Short bias

Hedge fund potential Return


benefits and risks
Risks
--> Problems
Hedge fund valuation
Hedge fund due diligence
Management fee
Types of fee
Incentive fee
"2 and 20"
1) any gains in value
f. HF fees 2) any gains in value in
Profits can be
excess of management fee
3) gains in excess of a hurdle rate
High water mark

For Funds of funds additional fees "1 and 10"


Leveraged Management buyouts (MBOs)
buyout (LBOs) Management buy-ins (MBIs)

invest in companies in the early stages


often equity
forms of
investment but can be convertible preferred a
Basic shares/ convertible debt
Private high risk --> returns on successful company can be very high
equity portfolio company
strategies Venture
capital (VC) closely involved

Angel investing
1. Formative stage Seed stage
Stages Early stage
2. Later stage
3. Mezzanine-stage

Other private equity Developmental capital/minority equity investing


strategies Distressed investing

Legal structure Limited partnerships


Private equity
structure and
Committed capital drawn down
Fees

Management fees
b,d,e. Fees clawback provision
Incentive fees
PRIVATE
EQUITY

1. Trade sale
Private equity 2. IPO
60.2. exit strategies
3. Recapitalization
Alternative 4. Secondary sale
Investments
5. Write-off/liquidation

Private equity potential Return


benefits and risks
Portfolio diversification benefits
---> Bias

Private equity Market/comparables approach


company valuation
DCF
Asset-based approach

Private equity due diligence


Residential property
Commercial real estate
Forms of
real estate REITs
investment
REAL Timberland
ESTATE Farmland
a
Potential benefits and risks of real estate
Comparable sales approach
Real estate valuation Income approach
Cost approach
Real estate investment due diligence

Direct investment
Commodity derivatives
ETFs
Equities that are linked to a
b,d,e. Forms of investment commodity
Managed futures funds
Individual managed account
Specialized funds in specific
COMMODITIES commodity sectors
Potential benefits and risks of
commodities
Commodity prices and
investments
Future price ~=
Contango vs. Backwardation
Commodity futures pricing 1. Roll yield
Sources of commodities
2. Collateral
futures returns
3. Change in spot prices

60.3.
Alternative
Investments

rare wines
art
Tangible
collectibles rare coin
stamps
valuable jewelry and watches
b,d,e sports memorabilia
(cont.).OTHER
No income generation but owners
ALTERNATIVE do get enjoyment from use
INVESTMENTS
Characteristics Storage cost may be
significant (art, wine)
Specialized knowledge is required
Markets are illiquid

Diversification
c. Potential benefits of AI Return

g. Risk management of AIs

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