ALTERNATIVE INVESTMENT FEATURES, METHODS, AND STRUCTURES:

 Alternative investments – investment that do not fall under traditional investments.

 E.g. – hedge funds, private equity funds & real estate investment etc.
 Benefits – risk reduction from diversification – due to low correlation with traditional
investment.
 Higher returns from illiquid securities.

Alternative investment features:

 Specialized knowledge required.

 Low correlation on traditional investment
 Less liquid assets held. Long time, Large size of investment

Characteristics:

 Investment structure facilitate direct investment by managers.

 Information asymmetry between fund managers and investors.
 Difficulty in appraising performance – such as more problematic & less available historical
returns & volatility data.

We classify alternative investment in 3 categories: Private capital, Real assets, hedge funds.

1.Private capital: includes private equity & debt

 Private equity funds – Invest in firms – want private fund. Are at mature or decline stage.
 LBO funds use borrowed money to purchase equity in established companies.
 Venture capital – invest in unproven comp. at start up or early stage.
 Private debt funds – Make loans, lend to early stage or invest in debt – in struggling firms.

2.Real assets – include real estate, infrastructure, natural resources & other asset like digital asset.

 Real estate investment – Include residential or commercial prop & real estate backed debt.
 Structures – full or leveraged ownership of Indi. Properties, LP, back by loan, publicly traded
securities backed by pools of properties
 Natural resources – commodities, farmland & timberland. Investors can own them in
physical form, comm. Derivatives or equity of commodity producing firms.
 Some funds seek exposure to returns by holding derivatives.
 Farmland – produce income by leasing, farming or livestock for harvest & sale.
 Timberland – investment involves purchasing forested land & harvesting trees to generate
CF.
 Infrastructure – refers to long lived assets that provide public services.
 Include eco & social infra. Asset.
 Often financed & constructed by govt. infra. Investment have more recently undertaken by
public private partnerships, which each holding significant stage in infra. Assets.
 Assets may revert to public ownership at some future data.
 Other types of real assets – art, patents and digital asset like crypto etc.

3.Hedge funds:

 Are invest. Companies open to only qualified investors.

 They use leverage, hold long and short position, use derivatives and invest in illiquid assets.
 They use many different strategies.
Fund Investing:

 Term sheet – has investment policy, fee structure & requirement to participate.
 For a fund manager, permitting co-investment may increase the availability of investment
funds and expand the scope and diversification of the fund’s investments.
 Investing in asset pool using manager. Don’t have control over selection of asset or sale.
 Larger cap. Commitment, less info on earning, high management fee.

Co-investing:

 Investors contribute of pool of invest. But have right to invest along manager.
 Reduces overall fees, benefiting from manager expertise. Investor – gains skills & expertise.
 Co-investing – increases availability of investment funds & diversification of funds

Direct Investing:

 Purchasing asset itself. May purchase private comp. or real estate directly.
 Advantage – no fees to manager. Investor has more control over investment.
 Disadvantages: possibility of less diversification, high min. investment amounts. & greater
investor expertise required to evaluate deals.

Ownership structure of alternative investments:

 Structured as limited partnership. GP is fund manager & makes decision. LP are investors
who own share to them invest. Amount.
 LPs – do say in fund mgmt. & no liability beyond their investment. Max no. of LPs is set in
partnership.
 LP – commit to invest. Amt, in some case only a portion, providing remaining over time as
required by GP.
 GP – less regulated, LP shares available to investors only who can bear risk.
 Rules % ops detail – LP agreement. Special terms – side letters.
 Some limited partners may require special terms offered to other LPs also offered to them.
Known as most-favoured-nation clause in side letter.
 MLP (Master limited partnership) fund can be structured that can be publicly traded. It
specialises in real estate & natural resources.

Fee structures:

 Total fees = Mgmt. fee & performance or incentive fee (also called carried interest)
 Mgmt. fee for hedge fund – calculated as %of asset under management
 Mgmt. fee for private equity fund – calculated as %of committed capital
 Committed capital is usually drawn down over three to five years, but the drawdown period
is at the discretion of the fund manager.
 Committed capital – not yet drawn – called dry powder.
 Reason for it is otherwise fund manager would have an incentive to invest capital quickly
instead of selectively.
 Performance fees – portion of profits of investment.
 Agreement: specifies hurdle or preferred return that must have met for exceed for perf.
Fees. Hurdle rate – soft or hard.
 Soft - %of total increase in value of each partner’s investment
 Hard –as only of gains above hurdle rate.
 E.g. – Hurdle rate – 8%. Produced return of 12%. Performance fee structure 20% of gains.
  If soft, 2.4%, If hard, 0.8%
 Performance fees – paid at the end of each year based on increase in value of funds, after
management fees & other chargers.
 A catch up clause – is based on hurdle rate. A catch-up clause would result in the first 8% of
gains going to the LPs and the next 2% going to the GP, allowing the GP to “catch up” to
receiving 20% of the first 10% of gains. After the catch-up, further gains are split 80/20
between the LPs and the GP.
 High water mark – means no performance fee is paid on gains that only offset prior losses.,
performance fees are only paid to the extent that the current value of an investor’s account
is above the highest net-of-fees value previously recorded. Because investors invest in a
fund at different times, they each may have a different high-water mark value.
 Partnership waterfall – refers to way in which payments are allocation to GP & LP as profits
& losses are realized on deals. With deal by deal waterfall – profits are distributed as each
fund is sold & shared according to partnership agreement. This favours GP because
performance fees are paid 100% of LPs original investment + plus hurdle rate is returned to
them.
 European waterfall - the LPs receive all distributions until they have received 100% of their
initial investment plus the hurdle rate.
 A clawback provision would allow the LPs to recover these performance fees to the extent
that the subsequent losses negate prior gains on which performance fees had been paid.

ALTERNATIVE INVESTMENT PERFORMANCE AND RETURNS:

Risk AI > TI

Risks arise from:

Timing of CF over investment life cycle:

 AL has 3 phases of life cycle:

 Commitment phase – manager identify investment & making cap calls for partners. Make
calls as they identify investment which need cash. Returns – negative, due to long term
nature.
 Deployment phase – the manager’s funds & often involve themselves directly in firms &
project in which they invest. Returns – negative, are in start-up comps. Or troubled firm
 Distribution – Fund investment succeed & generate income & CF, Returns – positive.

J-curve – reflect all 3 phases in graph form. May reach plateau towards end of fund as manager exit.

 Variability over CF over funds life & timing of decisions, after tax CF & IRR, app. Measure of
after tax invest. Performance. Drawback – assume. of COC for CF & reinvestment rate of CF
  Measure of investment success – multiple of invested capital. Ratio of total cap returned +
value of any remaining asset/total capital paid over life of investment. But does not consider
timing of CF and outflows, therefore not used.

Use of Leverage:

 Some AI, use borrowing – to magnify gains.

 Hedge funds may arrange margin financing with prime brokers or employ leverage by means
of derivatives.
 To state effect of leverage on returns, consider a fund that can invest the amt. V0 without
leverage & earn the rate of return r.
 The funds unleveraged portfolio = r X V0.
 Now say, fund can borrow the amt VB at interest rB, and earn r by investing the proceeds.
 The fund’s leveraged portfolio returns, after subtracting the interest cost, then becomes:

 Thus, stated as a rate of return on the initial portfolio value of V0, the leveraged rate of
return is as follows:


 Risk – Lenders may limit access to add. Borrowing.
 Lender may issue margin call if equity decrease below a certain level. This can result to
realize loss by liquidating or closing position

Valuation of Investments:

AI – has illiquid asset not frequently traded. FV for these on assumptions.

FV hierarchy groups these assumptions in 3 levels.

 L1 – Assets trade in markets & have price available. Exchange traded securities.
 L2 – Asset do not have available quoted prices, but they can be valued based on direct or
indirectly observable inputs, such as derivatives.
 L3 – Asset require unobservable inputs to establish fair value, like real estate or private
equity investments for which there have been few or no market transactions.
 For L3, the absence of market activity can result in valuations that remain near their initial
costs for long period.
 As a result, values might not reflect the actual exit cost of investments.
 This lack of change in fair value can make AI appear higher, less risky & less correlated than
they are.

Calculate and interpret alternative investment returns both before and after fees:

 We have seen how margin calls may require a leveraged fund to exit investments at
unfavourable prices & unintended times.
 Same risk comes from investor redemptions. The more negative fund’s return, the more
likely investor will ask manager to redeem positions.
 For this, J Curve effect of negative returns in early years, AI funds take measures to restrict
early redemptions.
 Lockup period – time after initial investment over which LP either cannot request
redemptions or incur significant fees for redemptions.
  A notice period – 30 to 90 days is amt of time fund has to fulfil a redemption request.
 Notice periods – allow time for managers to reduce positions in an orderly manner.
 Funds managers – incur significant transaction costs when they redeem shares.
 Redemption fees can offset these costs.
 Managers can implement a gate that restricts redemptions for a temporary period.
 Customized fee structure – contained in side letter with individual investor detailing how it
differs from those in std. offering documents.
 Investors making large capital commit. = negotiate lower fees or better liquidity (shorter
lockup & notice) Hurdle rates, catch-up provisions may be subject to nego.
 Early investors – receive lower fees or better liquidity as incentive to invest in fund. Known
as founder class shares.
 Annual investor fees can also be either or fees, the max of management fee or incentive fee.
 Under such structure 1% management fee & 30% incentive fee, investor fees each year
would be simply be management fee unless calculated incentive fee is higher.

Biases in Alternative Investment Returns:

 There are AI indexes to measure historical performance

 But do not provide meaningful info on asset class because each one has unique structure &
different phases of lifecycle
 One way to tackle – compare funds that originate in same vintage year.
 Effect of survivorship bias – greater for hedge fund database because 25% HF fail in first 3
years. An index – does not include failed funds – overstate returns of hedge funds.
 These effects magnified by backfill bias – occurs when managers select only successful funds
for index inclusion.

Return Calculations for Alternative Investments:

Before fee returns on AL are calculated the same way as we calculate return on any investment.

Calculating after-fee returns simply requires adjustment of the cash flows or values for the various
fees involved, typically management and performance fees. For a simple case in which management
fees are a fixed percentage of end-of-period assets and performance fees are a fixed percentage of
total return with no hurdle rate, we can state the general partner’s total fees in money terms as
follows:
Fee structure provisions, such as hurdle rates and high-water marks, make calculating total fees
more complex than this simple formula. Other provisions may state whether the performance fee is
net of the management fee or independent of it, or whether the management fee is based on
beginning-of-period assets or end-of period assets.

INVESTMENTS IN PRIVATE CAPITAL: EQUITY AND DEBT:

Private capital:

 Funding provided to companies not raised from public markets. Private equity & debt.
 Private equity funds – invest in companies that plan to take private or early in companies
lives.
 PEF invests – called portfolio companies.

Private Equity Investment Categories:

 LBO fund – which acquires public companies with large % of purchase price financed by
debts. Way for company to go private – after this transactions, no longer publicly traded.
 In an LBO, private equity firm seeks to add value by improving or restructuring the portfolio
company’s ops. To increase its sales, profits & cash flows.
 CFs can be used to service & pay down the debt taken to fund the acquisition.
 2 types of LBOs are –
 Management buyouts – Existing management team participates in purchase.
 Management buy ins - Company’s current management team replaced with a new team.
 Venture capital provides financing in early stages of developments.
 They typically receive common equity interest in portfolio companies but get convertible
debt or preferred stock.
 Convertibles security – align the investors of VC & start up firm, both increasing the value of
firm, but give the VC investors a higher priority of claims in the event of liquidation.
 We can classify VC investments by the portfolio company’s stage of development:
 Formative stage – earliest period of firm & has 3 stages:
 Pre seed capital /Angel investing – provided at idea stage. Used for business ideas &
assessing market potential. Financing amts – small
 Seed stage financing or seed capital – generally supports product development, marketing &
market research. Is the first stage which VC funds usually invest.
 Early-stage financing or start-up stage financing refers to investments made to fund
operations in the lead-up to production and sales.
 Later-stage financing or expansion venture capital This is after production & sales has begun.
Used to support initial growth, expansion, marketing. In this stage, owners often sell control
of company to VC investors.
 Mezzanine-stage financing Refers to capital – provided for IPO. IS used to indicate timing of
financing. Similar term, mezzanine financing can use these but it consists of equity or short
time debt.
 Private equity – in minority stake – less than controlling. One way to make investments in
this is – private investment in public equity. A private offering to institutional investors allow
a public firm to raise capital more quickly & cost effectively with fewer disclosures & lower
cost.

Private Equity Exit Strategies:

Avg holding period – 5 years.

1.Trade sale – direct sale. Advantage – investor pays premium to realize execution & lower
transaction cost. Disadvantage – resistance from management & limited potential buyers.

2.Public listing. Listing on a stock exchange can take place through an IPO, a direct listing or SPAC

1.IPO – most common method. Use investment banks – to underwrite offering. Realize
higher price for a portfolio company. Improve visibility to investors & public. Involves high
transaction cost.
2.Direct listing – Stock of company is floated on public market without underwriters.
Decrease cost, but does not raise new cap. For portfolio company.
3.SPAC – investment vehicle – to raise capital through IPO with purchase of acquiring an
existing company
a. Formation – formed by group of investors or sponsors.
b.IPO – goes public, after raising funds. Funds are placed in trust acc. Until target company is
identified.
c.Acquisition.
d.Post-acquisition – After merger, acquired company becomes publicly traded & investors
may choose to remain invested in new entity or redeem the shares.
SPAC popular due to ability to provide a faster route to go public. Uncertainty of find a target
& dilution of shares.

3.Recapitalization: Debt is issued to fund dividend distribution to equity holders. Not an exit – but
allows private equity fund to extract money from company – to pay its investors.

4.Secondary sale: Sell a portfolio company to another private equity firm or a group of investors.

5.Write-off/liquidation: Reassess and take losses from an unsuccessful investment in a portfolio

company

Risk and Return from Private Equity Investments:

 Returns = Equity funds > stock returns. Std Deviation – Private equity > equity index

 Private equity indexes rely on self-reporting & subject to survivorship & backfill biases, both
which lead to overstated returns.
 Because portfolio companies are revalued infrequently, measures of volatility and
correlation with other investments may be biased downward.

Private debt:

 Direct lending – Refers to loans made directly to company. Debt is typical secured with
covenants to protect the lender.
 A leveraged loan - Made by private debt fund – using borrowed money.
 Venture debt - Funding by VC to start-up or early stage firms not yet profitable. VC debt –
often convertible to stock or combined with warrants. May favour VD because – allows to
maintain ownership & control.
 Mezzanine debt is private debt that is subordinated to senior secured debt. Features –
conversion rights or warrants, to compensate investors for add. Risk.
 Distressed debt of mature comp. in bankruptcy or default. In many cases, the fund becomes
active in restructuring the existing debt or making other changes that increase the value of
the acquired debt. Some distressed debt investors specialize in identifying otherwise good
companies with temporary cash flow problems, anticipating that the value of the company
 and its debt will recover. Others focus on turnaround situations, acquiring a company’s debt
with an intent to be active in managing and restructuring the company
 Unitranche debt combines different classes of debt (secured and unsecured) into a single
loan with an interest rate that reflects the blend of debt classes. The resulting debt typically
ranks between senior and subordinated debt

REAL ESTATE AND INFRASTRUCTURE:

Real estate:
 Provide income – in form of rent as well as price appreciation.
 Investment – directly or indirectly through limited partnership & publicly traded securities.
 4 categories of commercial estate- offices, shopping, industrial, rental.
 Real estate – described as quadrant. In first vertical investment is differentiated between
public & private real estate.
 Real estate – can be described in terms of quadrant. Investment is differentiated between
public & private real estate.
 In private – ownership = direct investment, like purchasing property or lending to purchase.
 Can be owned by single or indirectly owned through partnerships – where GP provides
services & LP are investors.
 Public market – Ownership involves securities that serve as claims on underlying assets.
 Public real estate investment includes ownership of Real estate investment trust shares,
equity in real estate company, exchange traded funds, residential mortgage backed
securities, commercial mortgage back securities, mortgage REIT & ETFS.


 Second horizontal dimension – describes whether investment debt or equity.
 Equity investor – has ownership of entity, controls decisions like exit, mgmt., exit.
 Debt investor – lends that owns a mortgage or mortgage backed securities. Mortgage is
secured by underlying real estate.
 Lender has higher claim priority in default.
 Because the lender must be repaid first, the value of an equity investor’s interest is equal to
the value of the property less the value of outstanding debt.
 Each form has its own risks, expected returns, regulations, legal issues & market structure.
  Private real estate investments are larger because real estate in indivisible and illiquid.
 Private real estate investments – large because RE is indivisible & illiquid.
 Public real estate investments – investors can divide ownership without dividing property.
 As a result, public real estate is liquid & enable investors to diversify.
 Private real estate – requires property management expertise on part of owner.
 Public – the real estate – is professionally managed.

Direct Real estate investment:

 Benefits of direct investment include the following:

 Control – owner has decision making – on selling, marketing, financing etc.
 Diversification – Real estate – less than perfectly correlated to returns of stock & bonds.
 Adding private real estate investment to a portfolio can reduce risk relative to the expected
portfolio return
 Tax benefits – can provide deductions for noncash depreciation as well as interest expense.
 Drawbacks:
 Illiquidity and price opacity
 Complexity of mgmt.
 Need for specialized knowledge about current market conditions
 High initial investment/capital needed
 Concentration risk if a portfolio has one or few properties

Indirect Real Estate Investment:

 Through LPs, JCs & publicly traded securities. REITs do not face redemption or liquidity risk.
They exempt from double taxation. REITs – have managers to invest in properties. REITs
report GAAP metrics – like EPS. Some provide net asset value also.
 Types of RIETs – equity REIT, which invest in RE directly or via partnership, mortgage REIT,
they lend money for RE or invest in MBS/CMBS, or hybrid REITs that invest in RE &
mortgages.
 RIETS with core strategies – invest high quality properties that give stable returns. This
structure allows investors to invest or redeem at any time. REITs have open end structure –
with indefinite lives.
 REITs with riskier investment strategies are most often structured as closed-end funds with
finite lives. These strategies include:
 Core-plus real estate strategies, which accept a bit more risk than core strategies by
undertaking modest development and redevelopment.
 Value-add real estate strategies, which undertake development and redevelopment on a
somewhat larger scale than core-plus strategies.
 Opportunistic real estate strategies, which pursue large-scale redevelopment and
repurposing of assets, invest in distressed properties, or speculate on upturns in real estate
markets.

Explain the investment characteristics of real estate investments:

 In RE investments – First mortgages or investment grade CMBs – least risky. Core strategies
next least risky. Value add & opp. Strategies – most risky & like equity in risk & return.
 REITs – invest in many properties, provide diversification benefits, liquidity. Correlation is
higher of REIT with equity returns – than for direct investment. RE investment do improve
risk return profile of a portfolio.
Infrastructure:

Infra investments – include transportation assets, utility assets, info & tech assets, social infra.

Way to invest – construct, sell or lease asset to govt or operate directly. Investor may be buy asset
back from govt to operate. Can be made by public private partnership also.

CF generated from infra investment – include availability for making infra available, usage based
payments – like toll, take or pay arrangements that require buyer to pay min. purchase price for an
agreed value.

 Investment in asset – already constructed – brownfield investments. E.g. – privatization of

public asset. Brownfield which are fully operational – called secondary stage investment.
 Investment in asset – to be constructed – greenfield investments. Greenfield investments
typically follow the build-operate-transfer (BOT) life cycle.
 Infra assets – have long life and are quite large in cost & scale – direct investment in them
low liquidity. More liquid investments backed by infrastructure assets are available through
ETFs, mutual funds, private equity funds, or master limited partnerships (MLPs).
 Publicly traded vehicles for investing in infrastructure are a small part of the overall universe
of infrastructure investments and are relatively concentrated in a few categories of assets.
Debt issued to fund infrastructure can be privately placed or publicly traded.

Explain the investment characteristics of infrastructure investments:

 Investing in brownfield – provides stable cash flows & high current yield but offers little
potential for growth.
 Secondary stage brownfield – less risky & offer low returns.
 Greenfield – are subject to more uncertainty & may provide relatively lower yields in near
team but has great growth potential. Infra projects that rely on revenue from uncertain
future demand tend to be riskiest.
 Because of long term contracts & barriers to entry – CFs in infra are stable & have low
correlation with public entities. Infra debt – safer & less affected by eco. Cycles. Greenfield
investments in developing economics, while risky have generated attractive returns over
long term as they benefit from increasing per capita income & wealth.
 Investing in infra – provide diversification benefits, investors must be aware that these
investments are subject to regulatory risk, leverage & possibility of less CF.
 Projects involving building assets have construction risk, operation risk.
 Infra investment – suitable for long term institutional investors like pension plans, life
insurance comp. & sovereign wealth funds.

NATURAL RESOURCES:

FARMLAND, TIMBERLAND, AND COMMODITIES:

 Natural resources – include raw land, land used for crops, timber and commodities.
 Investment in Natural resource can be direct or via commingled funds like ETF, REITs, limited
partnerships & limited liability companies.
 Derivatives like – commodity futures & swaps are also commonly used for exposure of this
asset class.
 Raw-land, farmland & timberland – illiquid investments & value is driven by location.
 For timber, farmland – proximity to transportation & markets increases value as does access
to water & quality of soil.
 While all three kinds of land can generate lease income and price appreciation, farmland and
timberland also generate income from their output
 Farmland – held by individuals, institutions most likely investors in raw & timberland.
 Timberland size > farmland. Timberland – requires specialized expertise.
 Investors who lack expertise can invest through timberland invest. Management orgs.
 Farmland & timberland are financed often in form of bank loan or direct private debt.
 Newer REITs in farmland allow retail investors to get a foothold in this category
 Choice to harvest timber is based on current prices & expected growth rates.
 Because commodity price fluctuates, farmers often use short positions in commodity futures
to hedge their expected harvest.
 Agricultural crops consume carbon therefore they are attractive to investors with ESG focus
on climate change.

Describe features of commodities and their investment characteristics:

 Commodities can have divided in 3 sectors – metals, agri & energy products.
 Commodity contracts are also classified based on grade (quality) and delivery location.
 Govts provide subsidies for some food crops for consumers or price supports to farmers.
 They may control access to extractable natural resources or be directly involve in
production.
 Climate change–related regulation may decrease demand for fossil fuels while increasing
demand for minerals such as lithium, cobalt, and nickel.
 It is possible to invest directly in commodities, derivatives such as futures are more
commonly used to gain exposure to commodities. Because commodities are physical goods,
they have costs for storage & transportation.
 Futures, forwards, and options on futures are all available forms of commodity derivatives.
Futures trade on exchanges and therefore have no counterparty risk
 Other methods of exposure to commodities include the following:
 Exchange-traded products (ETPs) include exchange-traded funds (ETFs) or exchange-traded
notes (ETNs). ETPs are suitable for investors who are limited to buying equity shares. ETFs
can invest in commodities or commodity futures and can track prices or indexes
 Managed futures funds like commodity trading advisers – are actively managed. Managers
concentrate on specific sectors, while others are more diversified. They can be structured as
LP with fees like Hedge funds & restrictions on partners, liquidity of investors.
 They can be structured as mutual funds also – shares publicly traded so that retail investors
can benefit from professional management. Structure- allows lower min. investment &
offers greater liquidity than limited partnership structure.
 Separately managed accounts (SMAs) are appropriate for larger investors who may require
custom portfolios based on their individual preferences and needs.
 Specialized funds in specific commodity sectors can be organized under any of the structures
we have discussed and focus on commodities such as oil and gas, grains, precious metals, or
industrial metals.
 Commodity Valuation:

Wheat today & wheat six months from today are diff. products. Purchasing the commodity
today will give the buyer the use of it if needed, while contracting for wheat to be delivered six
months from today avoids storage costs (warehouse cost, insurance, and spoilage) and having
cash tied up. An equation that considers these aspects is:

 Convenience yield – non monetary value of having physical commodity for use over
period of a future contract.
 If little or no convenience yield, net cost of carry will be positive, future price > spot price
– called contango.
 If convenience yield – high, net cost of carry negative, future price < spot price, called
backwardation.
 Contango decreases the return of long-only investors, while backwardation increases it.
 Spot prices for commodities – function of supply & demand. Demand – affected by value
of commodity to end users & by global economic conditions. Supply – affected by
production, storage costs & existing inventories. For many commodities, supply is
inelastic in short run because long lead times to alter production levels.
 As a result, commodity prices can be volatile when demand changes significantly over
the economic cycle, or when there are supply shocks such as natural disasters.
 Production of some commodities – agricultural commodities can be affected by weather
& plant disease, leading to high prices when production is low & low prices when
production is high. Costs of extracting oil and minerals increase as more expensive
methods or more remote areas are used. To estimate future needs, commodity
producers analyze economic events, government policy, and forecasts of future supply.
 In recent times, returns & volatility of returns higher for commodities than for global
stocks & bonds. Timberland & farmland – higher risks with lower volatility than global
stocks. As with other investments, speculators can earn high returns over short periods
when their expectations about short-term commodity price movements are correct
 Correlations of commodity return with return of global entity & bonds have been low.
Adding commodities to a portfolio of traditional assets can provide diversification
benefits. Because commodity prices tend to move with inflation rates, holding
commodities can act as a hedge of inflation risk. During periods of high (low) inflation,
commodities outperform (underperform) both stocks and bonds. Commodity prices are
more sensitive to geopolitical and weather-related risk factors.

HEDGE FUNDS:

 Hedge funds – private pooled investment vehicles – available only to qualified investors.
 Designed to use long & short exposures to generate gain in market.
 Hedge funds – lightly regulated, managers have great freedom in selecting strategies.
 Primary return drivers for this – market inefficiency & price volatility.
  They invest in traditional asset (debt & equity), use leverage & derivatives in pursuit of their
strategies.
 Evaluated on total return or risk adjusted return basis rather than bench mark.
 Managers often invest own money in their funds.
 Performance fees for a hedge fund manager may be linked to high water mark requirement,
whereby performance fees are payable only when fund value exceeds its highest prior value.
 Hedge funds are privately held. Unlike private equity funds, hedge funds tend to invest
mostly in liquid asset classes & have shorter time horizon.
 Private equity funds require a longer time horizon, while hedge funds have periodic
redemptions.

We can classify hedge funds by the strategies they pursue:

 Equity hedge fund strategies – seek to profit from long & short positions in publicly traded
equities & derivatives with equities in underlying asset.
 Short positions taken to reduce or remove overall market risk can be in a market index if a
manager does not have a negative opinion on specific securities. Subcategories include the
following:
 Fundamental long/short: Use long positions in undervalued securities on fundamentals while
same time have a short position in portfolio of stocks or an index.
 Strategy seeks to capture alpha when market correction occurs. Most managers have a net
long exposure
 Fundamental growth: Use fundamental analysis to find high-growth companies. Identify and
buy equities of companies that are expected to sustain relatively high rates of capital
appreciation, and short equities of companies expected to have low or no revenue growth.
 Fundamental value. Buy equity shares that are believed to be undervalued, and short
equities believed to be overvalued, based on fundamental analysis. The performance of
value stocks relative to growth stocks drives performance
 Market neutral. Use technical or fundamental analysis to select undervalued equities to be
held long and to select overvalued equities to be sold short, in approximately equal amounts
to profit from their relative price movements without exposure to market risk. Leverage may
be used.
 Short bias: Employ technical, quantitative, and fundamental analysis and take predominantly
short positions in overvalued equities, possibly with smaller long positions but with negative
market exposure overall. This is a contrarian strategy that focuses on the manager’s skills at
discerning flawed business strategies or accounting

Event-driven strategies are typically based on a corporate restructuring or acquisition that

creates profit opportunities for long or short positions in common equity, preferred equity, or
debt of a specific corporation. Event-driven funds are typically long biased. Subcategories are as
follows:

 Merger arbitrage. Buy the shares of a firm being acquired and sell short the firm making
the acquisition. Although the term arbitrage is used, such a strategy is not risk free
because deal terms may change or an announced merger may not take place
 Distressed/restructuring. Buy the securities of firms in financial distress when analysis
indicates that value will be increased by a successful restructuring, and possibly short
overvalued securities at the same time
  Activist shareholder. Buy sufficient equity shares to influence a company’s policies, with
the goal of increasing company value (e.g., by restructuring, change in strategy or
management, or return of capital to equity holders).
 Special situations. Invest in the securities of firms that are issuing or repurchasing
securities, spinning off divisions, selling assets, or distributing capital.

Relative value strategies involve buying a security and selling short a related security, with the goal
of profiting when a perceived pricing discrepancy between the two is resolved. Subcategories
include the following

 Convertible arbitrage fixed income. Exploit pricing discrepancies between convertible bonds
and the common stock of the issuing companies and options on the common shares
 Specific fixed income (ABS/MBS/high yield). Exploit pricing and quality discrepancies
 General fixed income. Exploit pricing discrepancies among fixed-income securities of various
issuers and types
 Multistrategy. Exploit pricing discrepancies among securities within and across asset classes
and markets.

Opportunistic strategies focus on macro events and commodity trading. Often, these strategies are
implemented using ETFs or derivatives in addition to individual securities. Subcategories include the
following:

 Macro strategies are based on global economic trends and events and may involve long or
short positions in equities, fixed income, currencies, or commodities. These funds benefit
from heightened volatility surrounding major events. Smoothing of economic shocks by
central bank actions reduce the attractiveness of these strategies
 Managed futures funds may focus on trading commodity futures (these funds are known as
commodity trading advisers, or CTAs) or incorporate financial futures. Commodity prices
tend to behave differently than financial assets, in that high prices tend to decrease demand
(which in turn decreases prices), while low prices reduce supply (which in turn increases
prices)

Unique Characteristics of Hedge Fund Investing:

Tend to be less regulated, to deploy range of strategies, use leverage & choose from a larger
universe of securities & derivatives. Hedge funds – higher cost as they charge higher incentive fee.

Have lower liquidity, including lockup period & liquidity gates. Lockup period – time after initial
investment – LP cannot request redemption or incur significant fees for redeem. (soft lockup) Notice
period – amt of time a fund has to fulfil a redemption request ion after lockup period is passed. A
liquidity gate is a partial restriction on redemptions.

Hedge managers – incur more costs when shares redeemed. Redemption fees can offset these costs.
Notice periods & liquidity gates allow time for managers to reduce positions in orderly manner.
Redemption often increase when hedge fund – poor performance, costs of honouring redemption
may further decrease the value of remaining partnership interest.

Reduced transparency about strategies & investment made to protect proprietary trading methods,
makes it difficult to assign accurate values to hedge fund’s holdings.

Hedge funds – can be commingled funds (many investors together or separately managed SMA.
Commingled funds – have master feeder structure – to be tax efficient, enjoy eco. Of scale, allow
global funding. 2 feeder funds – offshore (tax haven) & onshore. Both funds flow into a master fund,
which makes the investments. The master-feeder structure bypasses regional regulatory
requirements

SMA – allows customized portfolio to meet an investor’s risk/return objectives. Manager has no
stake in fund, interests may not be aligned with that of investors. SMA appropriate – for large or
institutional investors. The benefit of lower negotiated fees in SMA structure is offset by the
disadvantage of receiving allocations of only the fund manager’s most liquid trades

Hedge funds – structure – as limited partnership or LLC. GP is the fund manager – receives
compensation based on fund’s performance. GP & LP relation in fund document: partnership
agreement, private memorandum, articles of incorporation. Fund is structured as indefinite, most
funds do wind down as liquidated on regular basis.

Recently, there has been market pressure to reduce hedge fund fees from the previous standard of
2% management fees and 20% performance fees. Some of the newer funds have 1% management
fees plus 30% performance fees based on performance relative to a benchmark (as opposed to being
based on total returns).

Indirect Investment Forms:

A fund-of-funds is an investment company that invests in hedge funds. Fund-offunds investing can
give investors diversification among hedge fund strategies, offer a manager’s expertise in selecting
individual hedge funds, and provide smaller investors with access to hedge funds in which they may
not be able to invest directly. These funds also have reduced lockup periods and greater exit liquidity

Fund of funds manager – charge add. Fees beyond charged by individual hedge funds in portfolio.
These include – 1% management fee & 10% incentive fee. They can reduce net returns of investors
because of add. Fees.

Hedge fund returns come from three source

1. Market beta. This is the return attributable to the broad market index. Investors can get this from
passive investments in index funds.

2. Strategy beta. This is the return attributable to specific sectors in which a fund has exposure.

3. Alpha. This is the additional return that is delivered by the manager through security selection

Hedge funds – use leverage to magnify the value added through beta & alpha. High fees act as drag
on performance. Performance measured by indexes – often overstated. Indexes compile data by
voluntary reporting. This likely biases returns & correlations with traditional investment returns.
Because index reporting is voluntary, poor performing funds – less likely to report.

Index returns = survivorship bias – because hedge funds might not be included until they have
existed for a min. time or reach a min. size. Index – will not reflect poor performance in this case.

Selection bias may result from index providers assigning funds to categories inconsistently or having
different requirements for including a fund.

Backfill bias refers to the effect on historical index returns of adding fund returns for prior years to
index returns when a fund is added to an index. Like selection bias, this tends to overstate
performance because funds with better historical returns are more likely to be added.
Historical data show that while a hedge fund’s performance is highly dependent on the time period
over which the performance is measured, hedge funds as an asset class provide diversification
benefits relative to portfolios that invest in traditional asset classes. Hedge funds tend to be more
correlated with equities than with fixed income.