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Alternative Investments
Alternative Investments 2024 Level II High Yield Notes

LM01 Introduction to Commodity and Commodity Derivatives

Characteristics of commodity sectors

The following table summarizes the characteristics of six important commodity sectors:
Sector Description Storage/ Supply Demand
Transport
Energy Crude oil, refined Natural storage, Political events, Economic growth
products, natural pipes, ships new
gas technologies
Grains Corn, wheat, rice, Easy Weather, Humans, animal
soy; seasons disease, pests feed, fuel
Industrial Copper, Storage easy; Not impacted by Industrial growth
metals aluminum, nickel, transport can weather
zinc, lead, tin, iron be expensive
Livestock Poultry, sheep, Linked to grain Grain costs, Emerging markets
cattle, hogs costs weather, disease
Precious Gold, silver, Easy Not impacted by Inflation,
metals platinum weather technology,
jewelry
Softs Cotton, coffee, Difficult - Weather Wealth, emerging
(cash sugar, cocoa freshness is markets
crops) important
Commodity sectors life cycle

The following table summarizes the life cycle for six important commodity sectors (Copper
is used as an example for industrial metals; and coffee is used as an example for cash
crops):
Commodity Steps Seasons Considerations Contracts

Crude oil Input-output Extracted year Refineries and Futures

production life cycle: round; seasonal pipelines are contracts and
extraction, demand based very expensive indexes which
transportation, on weather. to build but follow local
storage, trading, these costs are grades and
refining, much lower than origins.
transportation and the cost of
trading exploration.
Natural gas Straight-through
consumption:
extraction,

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transportation,
storage, trading
Copper Input-output Extracted year Economies of Futures
production life cycle: round. scale; difficult to contracts come
extract, grind, reduce supply due every month
concentrate, roast, when demand is of the year.
smelt, convert, refine, low.
store and transport
Livestock Time to maturity Growth is year- Historically US Ranchers and
increases with size round; weight livestock exports slaughterhouses
Cattle: birth, feeder gain is are low because trade futures to
cattle, live cattle, influenced by of high risk of hedge exposure.
slaughter. weather and spoilage; now
pastures. this risk is lower
because of
advances in
cryogenics.
Grains Planting, growth, Well defined Stored in silos Farmers and
pod/ear/head seasons and and warehouses. consumers trade
formation, harvest. growth cycles. futures to hedge
Demand is year- exposure.
round.
Coffee Harvested somewhere year-round. Two major Two futures
Cycle: Plant, three to four years to bear varieties: contracts:
fruit (cherry), harvesting is done by robusta and robusta in
hand in multiple sweeps, two to three arabica. Brazil London and
weeks to dry, hulled, sorted and bagged produces both. arabica in New
for final market. Local buyer roasts and York.
ships to retail location.

Valuation of commodities

• Stocks and bonds are financial assets that represent claims against future cash flows.
They are generally priced based on the present value of cash flows.
• On the other hand, commodities generally do not generate a stream of cash flows,
therefore their valuation cannot be done on the basis of cash flows. Instead, the value of
a commodity is the discounted value of a future price. The future price depends on
factors such as supply, demand and expected volatility.

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Alternative Investments 2024 Level II High Yield Notes

• Investment in commodities is primarily done via derivative instruments such as futures

contracts. The price of commodity futures contracts is based on the current spot price
as well as the transportation and storage cost of holding a commodity.
• Future contracts can either be cash settled or require physical delivery. Market
participants may not always have the ability to make or take physical delivery, and this
factor can affect future prices.
• Hedgers can also impact futures prices as they regularly trade in order to hedge their
commodity exposures.

Futures market participants

Commodity market participants include:

• Hedgers – want to hedge their exposure to a commodity.
• Traders and investors
o Informed investors – take advantage of mispricing due to a lack of information
in the market place.
o Liquidity providers - trade with hedgers and effectively provide insurance
services.
o Arbitrageurs – seek to profit from mispricing between the futures price and
spot price.
• Commodity exchanges - determine contracts, rules and procedures for commodity
trading and act to ensure that market participants fulfill obligations.
• Commodity market analysts - perform research and analysis on commodities and
recommend investment positions.
• Commodity regulators – responsible for regulation of commodity markets.

Spot and futures pricing

Spot price is the current price of a commodity for immediate delivery at a specific location.
Spot prices vary across different regions based on quality and local supply demand factors.
Futures price is the price for future delivery of a commodity of a specific quality at a
specific location.
The difference between the spot price and futures price is called ‘basis’.
• When spot price is higher than futures price, the market is in backwardation and
basis is positive.
• When the spot price is lower than the futures price, the market is in contango and
basis is negative.
The price difference between two contracts of different maturities is called the 'calendar
spread'.

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• Calendar spread = Price of contract maturing earlier - Price of contract maturing

later.
• Calendar spread is positive when the futures market is in backwardation and
negative when the futures market is in contango.
Commodity futures contracts can be either cash settled or require physical delivery.

Theories explaining futures returns

There are three theories of commodity futures returns:

1. Insurance theory: Commodity producers sell the commodity in futures market in
order to make their revenues predictable. This implies that the futures price must
be less than the spot price as a payment to the speculator for providing insurance to
the producer.
2. Hedging pressure hypothesis: Producers and consumers sell and buy
(respectively) in the futures market in order to remove price uncertainty. The
number of sellers as against the number of buyers would determine whether the
futures market would be in contango or backwardation.
3. Theory of storage: Commodity futures prices are affected by the costs of storage
and convenience yield. Convenience yield is inversely related to general available of
the commodity. Futures price = Spot price + Direct Storage costs - Convenience yield

Components of futures returns

The total return of a fully collateralized commodity futures contract is made up of:
1. Price return is produced by a change in spot prices.
Price return = (Current spot price - Previous spot price)/Previous spot price
2. Roll return is produced by closing expiring contracts and reestablishing the
position in far-dated contracts.
Roll return is sector dependent, it is positive when futures markets are in
backwardation and negative when futures markets are in contango.
Roll return can be significant for a single period but is a small percentage of total
return over multiple periods.
Gross roll return = (Near-term contract closing price – Farther-term contract closing
price) / Near-term futures contract closing price.
Net roll return = Gross roll return × Percentage of the position in the futures
contract being rolled.
3. Collateral return is the yield on securities that the investor deposits as collateral to
establish the futures position.
Collateral return = Risk free rate return

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Alternative Investments 2024 Level II High Yield Notes

Total return = price return + roll return + collateral return.

Commodity swaps

A commodity swap is a legal contract involving the exchange of payments over multiple
dates as determined by specified reference prices or indexes relating to commodities.
Swaps offer the participant greater customization relative to a futures contract. They also
offer the advantage of providing the participant with a series of futures contracts without
him having to actually manage multiple contracts.
Types of swaps:
• Excess return: party pays a premium and receives excess return over a strike price.
• Total return: party receives total return on a commodity or index.
• Basis: payments are based on two related commodity reference prices.
• Variance: variance buyer benefits if actual variance is higher than stated variance
and the direction of price move matters.
• Volatility: similar to variance swap except based on volatility and the direction of
price moves does not matter.

Commodity indexes - Key characteristics

Commodity indexes portray the aggregate movement of a basket of commodities. Key

characteristics of a commodity index include:
• Breadth of coverage - Number of commodities and sectors included in the index.
• Weights - Relative weights assigned to each commodity and the methodology for
determining these weights.
o Production weighted: a commodity sector’s weight is based on the level of
production or economic value of that sector. There could be a cap or floor on
the weight of a particular sector or commodity. In an upward trending
market production value weighted indexes will outperform.
o Equal weighted: all sectors have the same weight.
o Liquidity weighted: liquidity can also be considered in allocating the weight
of a sector.
• Rolling methodology: determining how contracts that are about to expire will be
rolled over into future months.
o A passive roll methodology typically involves owning ‘front contracts’.
o An active roll methodology would try to maximize roll yield.
• Rebalancing methodology: the methodology and frequency of rebalancing the
weights of individual commodities, sectors and contracts in the index.
• Governance: The process by which above mentioned characteristics are
implemented.

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Alternative Investments 2024 Level II High Yield Notes

In general, commodity indexes have a low correlation with traditional asset classes such as
stocks and bonds. However, the correlation across different commodity indexes (or futures
indexes) tends to be high.

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Alternative Investments 2024 Level II High Yield Notes

LM02 Overview of Types of Real Estate Investment

Real estate investment: Basic forms

There are four basic forms of real estate investments: public equity, private equity, public
debt and private debt. The following table presents some examples for each quadrant.
Public Private
Equity • Shares of REOCs • Direct investments in real estate,
• Shares of REITs, other listed including sole ownership and joint
trusts, exchange-traded funds ventures
(ETFs), and index funds • Indirect real estate ownership
through limited partnerships,
other forms of commingled funds,
or private REITS and REOCs
Debt • Mortgage REITs • Mortgages
• MBS (residential and • Private debt
commercial) • Bank debt
• Unsecured REIT debt
Each form has its own risks, expected returns, regulations, legal and market structures.
Investors can explore these characteristics and choose a quadrant that suits them.
• Private investments involve large investments and are illiquid. They also require
property management expertise.
• Public investments allow the ownership claim on a property to be divided. This
provides liquidity and diversification to the investors. Also, the properties are
professionally managed and no real estate management expertise is required on the
part of the investor.
• Equity investors take on more risk and therefore expect a higher rate of return than
debt investors. Their returns have two components: rent and appreciation of
property value.
• Debt investors get their returns from mortgage repayments and do not participate
in the appreciation of value of the underlying real estate.

Portfolio roles and economic value determinants of real estate investments

The motivations for investing in real estate are:

• Current income: Income generated by letting, leasing or renting the property.
• Price appreciation: Real estate prices rise over time.
• Inflation hedge: Both rents and property prices rise in an inflationary environment.
• Diversification: Low correlation with other asset classes such as stocks and bonds.
• Tax benefits: Some investors in certain countries may have potential tax benefits.

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Alternative Investments 2024 Level II High Yield Notes

The following exhibit presents major economic factors that affect demand for the major
property types.

Commercial property types

The types of commercial properties are:

• Office – Demand depends on employment growth.
• Industrial and warehouse – Demand depends on overall strength of economy and
economic activity.
• Retail – Demand depends on trends in consumer spending, which in turn depends
on the health of the economy, job growth, population growth and savings rate.

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Alternative Investments 2024 Level II High Yield Notes

• Multi-family – Demand depends on population growth and other demographics.

Due diligence for real estate investments

Due diligence of a property should include:

• Market review
• Lease and rent review
• Review costs of re-leasing space
• Look for supporting documentation
• Environmental inspection
• Physical/engineering inspection
• Review ownership history
• Review service and maintenance agreements
• Conduct property survey
• Verify property is compliant with zoning
• Verify property taxes, insurance and so on have been paid
Real estate investment indexes

The two main types of real estate investment indexes are:

Appraisal based indexes: These are based on appraisals. They suffer from appraisal lag
which underestimates volatility.
Transaction based indexes: These are based on actual transactions. The two main sub-
types are:
• Repeat sales index: Based on repeat sales of same property.
• Hedonic index: Does not require repeat sales of the same property, uses variables in
regression that control for differences.
Transaction based indexes are noisy and there may be random upward or downward
movements in the index.

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Alternative Investments 2024 Level II High Yield Notes

LM03 Investments in Real Estate Through Publicly Traded Securities

Types of REITs

Most REITs are structured as corporations or trusts. They are tax-efficient vehicles for
distributing earnings from rental income to shareholders.
A company must meet a number of criteria in order to qualify as a REIT. In most countries,
REITs must distribute 90%–100% of their otherwise taxable earnings, invest at least 75%
of their assets in real estate, and derive at least 75% of their income from real estate rental
income or mortgage interest.
The main types of REITs are:
• Equity REITs: Have ownership position in income-producing real estate.
• Mortgage REITs: Invest the bulk of their assets in loans secured by real estate.
Net asset value approach for REIT valuation

Net asset value per share (NAVPS) is the difference between a REIT’s assets and its
liabilities (all taken at current market values rather than accounting book values), divided
by the number of shares outstanding.
NAVPS = (Value of assets – Value of liabilities) / number of shares outstanding
The actual share price can be different from NAVPS. Shares can trade either at a discount or
a premium to NAVPS. NAVPS is the largest component of the intrinsic value of the stock.
NAVPS calculation
The current market value of real estate assets is calculated by capitalizing NOI. The market
values of other assets and liabilities are assumed to be equal to their book values.
The following exhibit provides an example of NAVPS calculation. It starts with the net
operating income (NOI) of a property and shows the various adjustments which need to be
made.
Office Equity REIT Inc. Net Asset Value Per Share Estimate
(In Thousands, Except Per Share Data)
Last 12-months real estate NOI $270,432
Less: Non-cash rents 7,667
Plus: Adjustment for full impact of acquisitions
4,534
(1)
Pro forma cash NOI for last 12 months $267,299
Plus: Next 12 months growth in NOI (2) $4,009
Estimated next 12 months cash NOI $271,308
Assumed cap rate (3) 7.00%

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Alternative Investments 2024 Level II High Yield Notes

Office Equity REIT Inc. Net Asset Value Per Share Estimate
(In Thousands, Except Per Share Data)
Estimated value of operating real estate $3,875,829
Plus: Cash and equivalents $65,554
Plus: Land held for future development 34,566
Plus: Accounts receivable 45,667
Plus: Prepaid/Other assets (4) 23,456
Estimated gross asset value $4,045,072
Less: Total debt $1,010,988
Less: Other liabilities 119,886
Net asset value $2,914,198
Shares outstanding 55,689
(1) 50 percent of the expected return on acquisitions was made in the middle of 2010.
(2) Growth is estimated at 1.5 percent.
(3) Cap rate is based on recent comparable transactions in the property market.
(4) This figure does not include intangible assets.
NAVPS is calculated to be $2,914,198 divided by 55,689 shares, which equals $52.33 per
share.

Relative value approach for REIT valuation

Funds from operation (FFO) is accounting net earnings excluding:

1. Depreciation charges on real estate
2. Deferred tax charges (deferred portion of tax expenses)
3. Gains/losses from sale of property and debt restructuring
Adjusted funds from operation (AFFO) is a refinement to FFO and is designed to be a
more accurate measure of current economic income.
AFFO = FFO – straight line adjustment – recurring maintenance type capital expenditures
and leasing commissions
In relative value approach, we use the P/FFO, P/AFFO, EV/EBITDA multiples to value
REITs. The main drivers behind these multiples are:
1. Expectations for growth in FFO
2. Risk associated with underlying real estate
3. Risk associated with capital structure and access to capital
P/FFO and P/AFFO Multiples: advantages and drawbacks
Advantages:
1. These multiples are widely accepted.

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2. Portfolio managers can put REIT valuations into context with other investment
alternatives. This makes it easier to compare REITs with other investments.
3. FFO estimates are readily available.
4. Multiples can be used in conjunction with growth rates and leverage levels for
relative value analysis.
Drawbacks:
1. Does not capture the intrinsic value of all real estate assets. For example, empty
buildings do not contribute to FFO but have value.
2. P/FFO does not adjust for recurring capital expenditures. Although P/AFFO
considers this, there are wide variations in estimates and assumptions.
3. One-time gains/losses create issues with this model.

Private vs. Public real estate investments

The following exhibit summarizes some of the key differences, advantages, and
disadvantages of public and private real estate investing.

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Alternative Investments 2024 Level III High Yield Notes

LM04 Hedge Fund Strategies

Classification of hedge fund and strategies

Hedge fund strategies are generally classified based on a combination of:

1. The instrument in which the manager invests
2. Trading philosophy followed
3. Types of risks the manager assumes
This reading classifies hedge fund strategies into the following categories and sub-
categories.
1. Equity strategies: focus on the equity markets.
• Long/short equity
• Dedicated short bias
• Equity market neutral
2. Event-driven strategies: focus on corporate events, such as mergers and acquisitions,
bankruptcy, etc.
• Merger arbitrage
• Distressed securities
3. Relative value strategies: focus on the relative valuation between two or more
securities.
• Fixed-income arbitrage
• Convertible bond arbitrage
4. Opportunistic strategies: focus on a multi-asset opportunity set using a top-down
approach.
• Global macro
• Managed futures
5. Specialist strategies: focus on niche opportunities that require specialized skill or
knowledge.
• Volatility strategies
• Reinsurance strategies
6. Multi-manager strategies: focus on creating a portfolio by combining two or more
strategies.
• Multi-strategy
• Fund-of-funds

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Alternative Investments 2024 Level III High Yield Notes

Equity strategies

Equity L/S strategies

• They have a global opportunity set and diverse investment styles, such as
value/growth, large-cap/small-cap, discretionary/quantitative, and industry
specialization.
• The approach towards short positions can vary
o Some managers use index-based short hedges to reduce market risk.
o However, most managers use single-name shorts to generate an additional
absolute return and improve portfolio alpha.
• Equity L/S funds typically have average exposures of 40%–60% net long. Long
positions are in the 70%–90% range, and short positions are in the 20%–50%
range.
• L/S equity funds typically aim to achieve annual returns similar to a long-only
approach but with standard deviations that are 50% lower.
• Use of leverage varies across different funds
o Funds that are more market neutral (i.e., have a smaller net long position)
tend to be more levered.
o Similarly, funds that use the quantitative approach (versus discretionary
approach) are more levered.
Dedicated short selling and short-biased
• This category of equity hedge funds has multiple flavors:
o Dedicated short selling: Fund managers take short-only positions in
overvalued equities. They vary their short exposure by holding variable
levels of cash. They are typically 60%-120% short at all times.
o Short-biased: Fund managers use a less extreme approach; they take both
short and long positions. However, the short positions dominate, and the
fund typically has a net 30%-60% short exposure.
o Activist short selling: Fund managers take short positions and publish
research supporting their bearish views. The idea is to get other investors to
sell their shares also so that the stock prices go down.
• The return goals are less than most hedge fund strategies. However, this low return
is compensated by the higher diversification benefit due to a negative correlation
with the broader equity market.
• A key risk of this strategy is that the lender may want the security back at an
inopportune time when the price is high, and there is a potential short squeeze risk.
Equity market neutral
• EMN hedge fund strategies take opposite positions in similar or related securities.
Portfolios are set up such that the expected portfolio beta is close to zero.
• EMN strategies include:

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o Pairs trading: Involves identifying similar under and overvalued equities that
have been historically correlated.
o Stub trading: Involves buying and selling stock of a parent company and its
subsidiaries.
Multi-class trading: Involves buying and selling different classes of shares of
the same company, such as voting and non-voting shares.
• Typically, portfolios are constructed using quantitative methodologies.
• Since many beta risks are hedged away, EMN strategies generally use high leverage.
• This strategy tends to produce modest returns with low volatility. Its risk-return
profile is similar to fixed-income.
• These strategies generate alpha without accepting any beta exposure.

Event-driven strategies
Merger arbitrage
• This a relatively liquid strategy because the underlying securities are liquid.
Leverage is used frequently to enhance returns.
• This strategy has left-tail risk; if the merger fails, then the losses can be substantial.
This risk increases in market stress periods.
• The merger arbitrage strategy can be viewed as selling insurance on the acquisition.
If the merger succeeds, then the hedge fund manager collects the spread for taking
on event risk. If the merger fails, then the hedge fund manager faces losses on his
positions.
• Alpha is generated by identifying suitable deals.
• While identifying suitable deals, a manager has to be careful about cross-border
deals and deals involving vertical integration. These deals carry higher risks and
therefore offer higher returns.
o Cross-border M&A typically involves two sets of government approvals.
o M&A deals involving vertical integration often face an anti-trust inquiry.
Distressed securities
• Distressed securities strategies focus on firms that either are in bankruptcy, facing a
potential bankruptcy or under financial stress. The securities of such companies
may be trading at a significant discount to its eventual work-out value.
• The bankruptcy process typically results in either: liquidation or firm re-
organization.
o In a liquidation, the company’s assets are sold off, and the proceeds are
distributed amongst different stakeholders based on their priority of claims.
o In a reorganization, the company’s capital structure is reorganized. Current
debtholders may exchange their debt for new equity shares. The existing
equity may be canceled and new equity issued. This new equity can be sold
to new investors to raise funds to improve the company’s financial condition.

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Alternative Investments 2024 Level III High Yield Notes

• The strategy offers higher returns and higher volatility as compared to other event-
driven strategies.
• The strategy is long-biased as it involves identifying undervalued securities and
taking long positions in them.
• It is a highly illiquid strategy. Pricing may involve ‘mark-to-model’ with return
smoothening.
• Since the strategy is already very risky, the use of leverage is moderate to low.

Relative value strategies

Fixed-income arbitrage
• The manager buys relatively undervalued securities and sells relatively overvalued
securities, with the expectation that the mispricing will go away over the investment
horizon.
• The attractiveness of returns depends on:
o Correlations between different securities. Higher the correlation, the higher
the probability of a successful trade.
o The yield spread pick-up available. Higher the yield spread, the higher the
profit.
o High number and a wide diversity of debt securities in different markets.
This makes finding relatively mispriced securities more probable.
• The yield curve and carry trades within the US government space are very liquid,
but this space also has the fewest mispricing opportunities.
• Liquidity for relative value positions generally decreases in other sovereign
markets, mortgage-related markets, and across corporate debt markets.
• Leverage is high, but it decreases with product complexity.
Convertible bond arbitrage
• The objective of this strategy is to extract the relatively cheap embedded optionality
of the convertible bond. But buying the convertible security also exposes the
manager to other risks, such as interest rate risk, credit risk, and market risk. These
risks can either be accepted or hedged away using a combination of interest rate
derivatives, credit default swaps, and short sales of an appropriate delta-adjusted
amount of the underlying stock.
• Liquidity issues in this strategy are driven by:
o Relatively small issue size and inherent complexities
o Difficulty in shorting equity
• This strategy involves buying the undervalued convertible bond and shorting the
stock.
• The number of shares to sell short is determined by the delta of the convertible
bond.

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Alternative Investments 2024 Level III High Yield Notes

o For convertible bonds with high bond conversion prices relative to the
conversion value, the delta will be close to 1.
o For convertibles with low bond conversion prices relative to the conversion
value, the delta will be closer to 0.
• The strategy will be profitable if the realized equity volatility exceeds the implied
volatility of the convertible’s embedded option.

Opportunistic strategies

Global macro strategies

• Global macro strategies focus on identifying trends in the global financial markets
using macro-economic variables.
• Global macro managers are more anticipatory compared to managed future
managers.
• Usually, a top-down approach is used. The opportunity set is diverse and includes a
wide variety of assets and asset classes.
• Both macroeconomic and fundamental models are used.
Managed futures
• The strategies are highly liquid and active across a wide range of asset classes.
• It is easier to take on high leverage as futures contracts provide high exposure with
relatively lower margins.
• Returns of managed futures strategies exhibit positive right-tail skewness in periods
of market stress, which is useful for portfolio diversification.
(Global macro strategies generally deliver similar diversification in stress periods
but with more heterogeneous outcomes)
• The return profile is cyclical and has high volatility.
• The use of a systematic approach is more common compared to the global macro
approach.

Specialist hedge fund strategies

Specialist strategies require highly specialized skill sets. They tend to focus on niche
markets. The typical objective is to generate uncorrelated and attractive risk-adjusted
returns.
Volatility trading
• Relative value volatility arbitrage strategies seek to buy cheap volatility and sell
relatively expensive volatility. They can generate alpha across different geographies
and asset classes.
• Another type of volatility trading involves taking long volatility positions. This
strategy is particularly useful because of the negative correlation between equity
volatility and equity returns (≈ -0.8). Volatility levels tend to go up when equity
markets fall.

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Alternative Investments 2024 Level III High Yield Notes

• There are multiple ways in which volatility trading strategies can be implemented:
Exchange-traded options, Over the counter options, VIX futures or options on VIX
futures, OTC volatility swap or variance swap.
Reinsurance/Life settlements
• A life settlement hedge fund manager analyzes and buys pools of life insurance
contracts offered by third-party brokers and effectively becomes the beneficiary.
The hedge fund manager looks for policies with the following traits:
o Surrender value being offered to the insured individual is relatively low.
o Ongoing premium payments are also relatively low.
o Probability is relatively high that the insured person will die sooner than
predicted by standard actuarial methods.
• A major benefit of this strategy is that it has no correlation with other hedge fund
strategies.

Multi-manager strategies

Fund-of-funds
• A fund-of-funds aggregates capital from different investors and allocates it to a
portfolio of separate, individual hedge funds running different strategies.
• FoF managers can pursue strategic allocation and tactical reallocation across
strategies.
• FoF offers better liquidity relative to individual hedge funds.
• However, an investor has to pay a double layer of fees when investing in the FoF.
Also, FoF’s cannot net performance fees across managers.
• FoFs offer stable, low volatility returns as compared to individual hedge funds. They
use a moderate level of leverage.
Multi-strategy hedge funds
• Multi-strategy hedge funds combine multiple strategies under the same structure.
• A multi-strategy hedge fund can reallocate capital to different strategies more
quickly and efficiently compared to FoF managers.
• The fee structure for these funds varies, but it is generally more investor-friendly as
compared to FoFs. This is primarily due to two reasons:
o Only one layer of fees is applicable.
o The general partner is responsible for netting risk.
• Multi-strategy hedge funds have generally outperformed FoFs, but they also had
higher variances and occasional large losses.
• These funds offer greater transparency as compared to FoFs.
• They use significantly more leverage relative to FoFs.

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Alternative Investments 2024 Level III High Yield Notes

Conditional factor risk model

• To analyze the exposure to different risk factors, conditional linear factor models
can be used.
• A basic form of a conditional risk factor model can be expressed as:
(Return on HFi)t = αi + βi,1(Factor 1)t + βi,2(Factor 2)t + … + βi,K(Factor K)t +
Dtβi,1(Factor 1)t + Dtβi,2(Factor 2)t + … + Dtβi,K(Factor K)t + (error)i,t
• To build the conditional factor risk model, the first step is to identify a
comprehensive set of risk factors.
• A four-step process called ‘stepwise regression’ is used to develop the model
further. With this process, we are less likely to include highly correlated risk factors.
• The curriculum uses such a model that incorporates four factors for assessing risk
exposures in both normal periods and market stress/crisis periods: equity risk,
credit risk, currency risk, and volatility risk.

Performance contribution to a 60/40 portfolio

Adding a 20% allocation of a hedge fund strategy group to a traditional 60%/40% portfolio
(for a 48% stocks/32% bonds/20% hedge funds portfolio) typically results in:
• Lower total portfolio standard deviation
• Higher Sharpe and Sortino ratios
• Lower maximum drawdown
This suggests that hedge funds act as both risk-adjusted return enhancers and diversifiers
for the traditional stock/bond portfolio.

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