ALTERNATIVE INVESMENTS PORTFOLIO MANANGEMENT Portfolio Management Prof Ali

ALTERNATIVE INVESMENTS PORTFOLIO MANANGEMENT Portfolio Management Prof. Ali Nejadmalayeri

Universe of Investments Universe of Investment Modern Alternative Investments Traditional Alternative Investments • Hedge Funds • Private Equity • Managed Futures • Commodities • Distressed Securities • Real Estate Traditional Investments • Stocks • Bonds

Concerns • • • Tax Issues Suitability Communication with Client Decision Risk Equity Stakes in Closely Held Companies

Real Estate • Type of Investments – Real Estate Investment Trust (REIT) • Equity REIT, Mortgage REIT, Hybrid REIT – Commingled Real Estate Fund (CREF) – Infrastructure Fund • Benchmarks – NCREIF, measure of direct investment • quarterly sample of commercial properties owned by large institutions – NAREIT, measure of indirect investment • Real-time, market-cap weighted all REITs in NYSE and AMEX • Other indexes as well produced by NAREIT

Real Estate: Characteristics • Investment Characteristics – Advantages • Tax subsidies, leverage, direct control of assets, geographical diversification, low volatility – Disadvantages • Divisibility, information asymmetries, high transaction costs, high operating costs, locality risk • Role as a Diversifier – Advantages • Some benefit but not when hedge funds and commodities considered – Geographical differences and return persistence

Private Equity/Venture Capital • Purpose – Early stage (seed, start-up, first-stage) and Largestage financing (2 nd, 3 rd and mezzanine financing) • Ventures – Angel Investor – Venture Capital Funds and Trusts – Mega- and Mid-Cap Buy-Out Funds • Benchmarks – Annualized IRRs by NVCA and Thomson Venture Economics

PE/VC: Characteristics • Private Equity Investment Characteristics – Illiquidity – Long-term Commitment – Higher risk than seasonal equity – Higher IRR – Limited Information • Private Equity vs. Venture Capital – Buy-out funds are highly levered – Cash flows to BO funds’ investors are often and steady – VC returns are more vague and uncertain

Commodity Funds • Types – Direct Commodity Investment • Purchase of physical commodities – Indirect Commodity Investment • Purchase of commodities-linked companies • Benchmarks – Goldman Sachs Commodity Index (GSCI) – S&P Commodity Index (S&PCI) – Dow Jones – AIG Commodity Index (DJ-AIGCI) • Benchmarks – Total return = collateral + roll + spot returns

CF: Characteristics • Investment Characteristics – Business Cycle related Supply & Demand – Convenience Yield • Future – spot = interest rate + storage + convenience – CY is the consumption timing option return – At low levels of inventory CY is high and vice versa – Real Option Yield • Backwardation (inverted future price curve) is a sign of real option under uncertainty • Role of Commodities – Potential Hedge Against Inflation – Risk Diversifier

Hedge Funds • Types – Equity market neutral: short + long positions – Arbitrage • Convertible Arbitrage: long CB + short stocks • Fixed Income Arbitrage: hedges against direction • Merger Arbitrage: long target and shorting acquirer – Distressed Securities: long distressed bonds – Hedged equity: unbalanced short + long – Global macro: major global trends – Emerging markets: long in EM stocks – Fund of funds: combo of hedge funds

Hedge Funds (Cont’d) • Benchmarks – Monthly • • • CISDM by the University of Massachusetts, 90 Credit Swiss/Tremont, 94 EACM Advisors, 90 Hedge Fund Intelligence Ltd. , 98 HFR, 90 – Daily • • Dow Jones Hedge Fund Strategy benchmark HFR Indices MSCI Hedge Invest Index S&P Hedge Fund indices

Issues with Hedge Fund Indices • Concerns about index construction – Selection, Styles, Weighting, Rebalancing, Investability • Alpha determination – How to measure of alpha • Biases in Indexes – Persistence of volatility thru time – Survivorship bias, poor tracks exit the index – Stale price bias, caused by infrequent trading – Backfill bias, missing parts of return in simulated

Hedge Funds: Characteristics • Investment Characteristics – Long-bias in return leads to less diversifier effect – Replication using stocks and option data is limited • Only reflects certain strategies – New frontiers: • Using stocks, bonds, commodities, etc as risk factors in hedge fund analysis, refer to Prof. Andrew Lo (MIT) • Role as Diversifier – Issues to consider in the context of MVO: • Persistence of performance, portfolio rebalancing, impact of highly non-normal return distributions

Decomposition of HF Returns • “CAN HEDGE-FUND RETURNS BE REPLICATED? : THE LINEAR CASE” Jasmina Hasanhodzica and Andrew W. Lo, Journal of Investment Management, 5(2), 2007, pp 5 – 45

HF Performance Evaluation • Questions – Return achieved? • Rolling return: 1/12 * [R t + … + R t – 12 ] – Volatility including downside risk • Downside deviation (DD): [1/12*∑{min(Rt – R*, 0)}2]1/2 – What performance measure is suitable? • Sharpe ratio: [Ret. – RF]/Std Dev. • Sortino ratio: [Ret. – RF]/Downside Dev. • Gain-to-loss ratio: [# Pos. / # Neg. ]*[Up Ret. /Dn Ret. ] – Correlations – Skewness and kurtosis – Consistency

Managed Futures • Types – Systematic trading strategies • rule-based trend following – Discretionary trading strategies • Based on portfolio managers’ judgments • Benchmarks – CISDM CTA • CTA$ dollar weighted index • CTAEQ equal weighted index

Managed Futures: Characteristics • Investment Characteristics – Zero-sum game; long-run return is risk-free rate – If hedgers pay a premium for liquidity, or arbitrage out inefficiencies • Momentum strategies can have excess return and impart the positive skewness • Options allow to trade on volatility patterns • Role as Diversifier – Can add value to stock/bond/hedge funds • Public commodity pools have had poor performance but private pools added value

Distressed Securities • Types – Hedge fund or Private Equity fund – Asset types • Public debt & equity of distress firms • Orphan equity: shares of reorganized firm • Bank debt or trade notes of distressed firms • Benchmarks – Distressed securities hedge fund indexes • CISDM, HFR, EACM – Altman-NYU Salomon Center Defaulted Public Bond and Bank Loan Index

Distressed Sect. : Characteristics • Investment Characteristics – Negative skewness and large kurtosis • Bad events happen more often than “normal” – Dependent on economic conditions – “Fallen Angel” phenomenon – almost like what is going on CDO market right now! • Role as Diversifier – Only 5% of institutional funds invest in DS!

Distressed Securities Strategies • Long-only Value Investing – High yield (Junk Bond) Investing – Orphan Equity Investing • Distressed Debt Arbitrage – Buy distressed debt and short distressed equity • Private Equity – Prepackaged bankruptcy (vulture funds) • Event risk, liquidity risk, market risk, J-factor risk