Lvl2: Alternative Investments

Energy

• Natural gas can be consumed almost immediately after extraction from the ground

• Crude oil, in contrast, has to be transformed into something else

• pipeline and tanker reliability, seasonality (summer/winter), adverse weather (cold, hurricanes), automobile/truck sales, geopolitical instability, environmental requirements, economic (GDP) growth

Industrial/Precious Metals

• most flexible life cycle

• can be stored for months (if not years) resistance to spoilage

• primarily influenced by central bank monetary policy, geopolitics, economic (GDP) growth

Livestock

• grows year round, but good weather and access to high-quality pasture and feed accelerate weight gain

• high risk of spoilage but advances in cryogenics

• Speed of maturation to slaughter weight, economic (GDP) growth/consumer income, disease, adverse weather

Grain

• demand for grains is year round

• primarily influenced by weather (moisture, temperature), disease, consumer preferences, genetic modification, biofuel substitution, population growth

Softs

• Coffee, cocoa, cotton, and sugar

• primarily influenced by weather (moisture, temperature), disease, consumer preferences, biofuel substitution, economic (GDP) growth/consumer income

Commodities

• tangible items with an intrinsic (but variable) economic value

• do not generate future cash flows beyond what can be realized through their purchase and sale

• derivative contracts

• incurs transportation and storage costs

backwardation vs contango

backwardation: spot price > futures price - positive calendar spread

contango: futures price > spot price - negative calendar spread

insurance theory

• normal backwardation

• futures price has to be lower than the current spot price as a form of payment or remuneration to the speculator who takes on the price risk

• but normal backwardation is not normal

Hedging Pressure Hypothesis

• when both producers and consumers seek to protect themselves from commodity market price volatility with hedges

• If the two forces are equal in weight, then one can envision a flat commodity curve

• if producers are more interested in selling forward, then backwardation

• if consumers are more interested in hedging, then contango

• One issue is that producers generally have greater exposure to commodity price risk than consumers do

Theory of Storage

• a commodity that is regularly stored should have a higher price in the future (contango) to account for those storage costs

• supply dominates demand > contango

• a commodity that is consumed along a value chain that allows for just-in-time delivery and use

• demand dominates supply > backwardation

Futures price = Spot price of the physical commodity + Direct storage costs (such as rent and insurance) − Convenience yield.

total return

price return + roll return + collateral return + rebalance return

• Price return = (Current price − Previous price)/Previous price

• Roll return = [(Near-term futures contract closing price − Farther-term futures contract closing price)/Near-term futures contract closing price] × Percentage of the position in the futures contract being rolled. i..e., contango = negative roll return

• collateral return = yield for bonds used to maintain investors futures position

• rebalance return - from rebalancing the index’s component weights

roll return

• industrial metals, agriculture, livestock, precious metals, and softs have statistically strong negative mean roll returns

• Only energy has a statistical possibility of a positive mean roll return - but diminished after 2010

commodity swap

• risk management and risk transfer

• total return swap - returns = change in the level of the index

• Basis swap - periodic payments are exchanged based on the values of two related commodity reference prices that are not perfectly correlated

• Variance/volatility Swaps - periodically exchange payments based on the proportional difference between an observed/actual variance in the price levels of a commodity and some fixed amount of variance

commodity index

• used as a benchmark to evaluate broader moves in commodity pricing

• for macroeconomic or forecasting purposes

• basis for an investment vehicle or contract

rebalancing frequency

• rebalancing is more important if a market is frequently mean reverting

• frequent rebalancing can lead to underperformance in a trending market because the outperforming assets are sold but continue up in price, whereas the underperforming assets are purchased but still drift lower

net operating income

NOI = Effective gross income – Operating expenses – Property maintenance allowance

effective gross income: gross rent * rentable space - vacancies

operating expenses: tax, insurance, service, repairs, utilities

property maintenance allowance: improvements/ maintenance capex (not to upgrade significantly)

LTV ratio

debt service coverage ratio

equity dividend rate

Pre-tax cash flow = Net operating income – Debt service.

After tax cash flows

After-tax cash flow = Pre-tax cash flow – Taxes

Taxes = t × (NOI – Interest expense – Depreciation expense)

REOCs vs REITS vs MBS

REOCs are taxable corporations that own, operate, and manage commercial real estate with few restrictions

• located in countries that do not have a tax-advantaged REIT regime

• development of for-sale real estate properties

• offer other non-qualifying services, such as brokerage and third-party property management

REITs are restricted to primarily owning and operating rental properties or purchasing mortgages and are required to distribute nearly all or all of their earnings to investors to avoid paying corporate income tax

• equity REITs - own real estate

• mortgage REITs - make or invest in loans secured by real estate

MBS

• rights to receive cash flows from portfolios of mortgage loans

FFO - Funds from operations

• common measure of REIT performance

FFO = Net income + Depreciation + Amortization – Net gains from property sales

• Investors believe that real estate maintains its value to a greater extent than other business assets so depreciation deductions under IFRS and US GAAP do not represent economic reality

Real estate - appraisal based vs transaction index

• Appraisal: combine valuation information from individual properties

• Transaction: actual transactions

• Appraisal based - tend to lag a rising/falling market

• may not be appraised every quarter

• If the index is used for comparison with other asset classes that are publicly traded, however, appraisal lag is more of an issue

• appraisal-based indexes may underestimate the volatility of real estate returns

Adjustment for Appraisal Lag

R_t^* = aR_t + (1 – a)R_t–1^*.

a reflects the speed at which actual returns are reflected in appraisal-based returns - higher a represents more rapid 0<a<1

Rt is actual return

Net Asset Value Approach

• includes:

• value of any non-asset-based income streams (e.g., fee or management income)

• value of non–real estate assets, including cash

• net of the value of any contingent liabilities

• value added by management of the REIT or REOC

NAVPS = (Market value of assets – Market value of liabilities)/Number of shares

NOI = (Gross rental revenue – Estimated vacancy and collections loss – Operating expenses).

• goodwill, deferred financing expenses, and deferred tax assets will be excluded to arrive at a “hard” economic value for total assets

• “soft” liabilities as deferred tax liabilities will be removed

• remove non-cash rent from straightlining

Investing in REITs

• Liquidity

• Transparency: Readily available share prices and transaction histories

• Diversification of property holdings: By property type, geography, and underlying tenant credit

• High-quality portfolios

• Active professional management

• Potentially stable income

• Tax efficiency: passthrough structures avoid corporate income taxation, leaving only the investor to pay taxes on dividends received - single tax

• Lack of retained earnings

• Regulatory costs

• Limited in types of assets owned

Relative Value Approach

Adjusted funds from operations

AFFO = (FFO – Non-cash rent – Recurring capex)

P/FFO and P/AFFO

P/FFO and P/AFFO Multiples advantages & disadvantages

• widely accepted in evaluating shares across global stock markets and industries.

• FFO estimates are readily available through market data providers

• can be used in conjunction with such items as expected growth and leverage levels to deepen the relative analysis

• may not capture the intrinsic value of all real estate assets held e.g. non-income-producing assets

• does not adjust for the impact of recurring capital expenditures

• more difficult to compute with increased level of such one-time items as gains and accounting charges,

Characteristics of hedge funds

• less regulatory constraints (except liquid alts)

• flexible mandates

• large investment universe

• aggressive investment style - risky

• liberal use of leverage

• liquidity constraints

• high fee structures- % of AUM for management fees and 10-20% of annual returns for incentive fees

classification of funds

• single manager fund - one strategy

• multi-strategy fund - multiple diff strategies

• fund of funds - capital allocated to separate hedge funds that themselves run a range of diff strategies

single hedge fund strategies

• equity-related - equity markets

• event-driven - M&A, bankruptcy, other events

• relative value - relative valuation between 2 or more securities - credit and liquidity risks e.g., fixed income arbitrage, convertible bond arbitrage

• opportunistic - top down multi-asset; e.g., global macro and managed futures

• specialist - niche opps that require specilized skill or knowledge e.g., volatility involving options and reinsurance

• multi-manager - multi-strategy or funds of funds

equity hedge funds

• long/short equity - long undervalued companies; short overvalued - defined by manager stock-selection skill - performance during market crisis periods is important

• dedicated short selling and short-biased - short-biased will balance with a modest index long exposure - stock selection -

• equity market neutral - take opp positions in similar or related equitues with divergent valuations - stub trading - parent & sub - multi class trading - classes of shares in same co - security selection and market timing - higher levels of diversification and turnover ratios - high levels of leverage

event driven strategies

• Merger arbitrage: buy the acquirer sell the target; equivalent to a short put and riskless bond

• Distressed securities -

relative value strategies

• fixed income arbitrage - long/short positions across a range of debt securities - require substantial leverage - carry trade to long a high yield security and short a lower yield security - yield curve trade to long/short at different points on the yield curve

• convertible bond arbitrage - hedge other risks embedded in the convertible security (ir rate, credit, market) to access the cheap convertible option - buy undervalued convertible bond and short overvalued stock - liquidity risk

opportunistic strategies

• Global macro strategies - wide range of asset classes - relative economic health and central bank policies of different countries - anticipatory

• managed futures - using futures, options on futures, forwards and swaps - pattern recognition trigger that is momentum/trend based

specialist strategies

• volatility trading - buy cheap volatility and sell expensive volatility -

• reinsurance/life settlements - life insurance - low surrender value low ongoing premiums will die earlier

multi-manager strategies

• FoF - diversification but double layer of fees lack of transparency

• multi strategy - can reallocate capital more quickly; full transparency; general partner absorbs the netting risk - quite levered