Ch. 20: Alt. Investments: Benefits, Risks and Structure

What is the second-most popular measure of risk for alternative investments?

drawdown amount

this is the maximum percentage decline in the alternative funds NAV over a specified time frame

what are the main three strategies a hedge fund manager can employ?

1. Relative value strategies

2. event-driven strategies

3. directional strategies

List some benefits of alternative mutual funds

• access to strategies formerly available only to exempt investors

• transparency, daily liquidity, and investor protection rights that are comparable to traditional mutual funds

• lower required minimum investment as compared to hedge funds

• generally lower fees as compared to hedge funds

what is “counterparty risk”?

“Counterparty risk” is a second-order risk driver for alternative strategies. It is the risk that the party on the other side of a trade does not meet their commitment under the terms of the trade.

what do “event-driven strategies” attempt to profit from?

attempt to profit from unique market events such as stock splits, mergers and companies buying back their own securitiesand corporate restructurings.

What is “leverage risk”?

“leverage risk” is a second-order risk driver for alternative strategies. It is the risk that an investor could lose money on borrowed funds.

what are the three main asset classes for alternative investments?

alternative strategy funds, alternative assets, and private equity

What three key factors are important to alternative investment product transparency?

1. the level of detail provided

2. the frequency of disclosure

3. the time lag between the reporting date (the as-of date) and the date the information is made available to investors.

What are the different categories of real estate?

“real estate” refers to land or any building situated on it and can be divided into the following three segments:

1. residential

2. commercial

3. industrial

why does adding alternative investments to a portfolio help to achieve a higher efficient frontier?

because of the different investment strategies that can be used.

Additional Learning:

the “efficient frontier” refers to the curve that reflects the most efficient portfolios for all levels of risk. Adding alternative investments to a portfolio can help achieve a new, higher efficient frontier because of the different strategies that can be used.

what is the intention of a hedge fund incorporating a “high-water mark”?

a high-water mark provision prevents a manager from being paid on repeat performance.

This means that the manager can only charge fees on new profits above the highest value previously achieved.

what do “directional strategies” attempt to profit from?

“directional strategies” employ strategies that attempt to profit form being on and anticipating the movement of various markets.

A hedge fund manager is attempting to profit from recent stock splits and mergers. What type of strategy is she employing?

an event-driven strategy

Additional learning:

event driven strategies attempt to profit from unique market events such as stock splits, mergers, companies buying back their own securities, etc.

List the different ways an investor can be considered eligible for prospectus exemption

• minimum investment exemption

• accredited investor exemption

• offering memorandum exemption

list some “second-order risks”

• liquidity risk

• leverage risk

• deal arbitrage risk

• default risk

• counterparty risk

• trading risk

Additional Learning

“first order risks” are related to the market.

“second-order risks” are not related to the market but to other aspects of trading.

what two pieces of data are used in the efficient frontier

standard deviation and expected return

why would adding alternative investments to your client’s portfolio most likely reduce the volatility of the portfolio?

a wide range of alternative investments exists with varying degrees of risk exposure. These investments can have a low or even negative beta as compared to traditional investments, which can add further layer of diversification to a portfolio. Diversification by holding alternative investments offers the following benefits:

• reduced volatility

• downside protection in choppy markets through reduced drawdowns

• greater allowance for the use of leverage due to the reduced risk

what are performance fees typically based on for traditional mutual funds, alternative mutual funds, and hedge funds?

for traditional mutual funds, the performance fee is allowed if the fee is tied to a benchmark or index.

for alternative mutual funds, the performance fee is normally based on the fund’s return.

for hedge funds, the performance fee is normally based on the fund’s cumulative return since the last performance fee was paid.

How much of a portfolio’s volatility results from its asset allocation?

40% to 90%

What could be consider

What is the name of the strategy used by hedge fund managers that attempts to take advantage of pricing or arbitrage opportunities in the market?

relative value strategy

Additional Learning:

for example, an arbitrage opportunity exists if an identical stock is trading at different prices on two different exchanges. the investor could buy the stock on one exchange and then sell it on the other exchange that has higher bid prices.

what is a “hurdle rate”?

the rate of return a hedge fund is required to earn before an incentive fee is paid to its manager.

Johnny told you he bough a “liquid alt”. What is he referring to?

Alternative mutual funds

“alternative mutual funds” are informally known as “liquid alternatives”, or “liquid alts”.

Johnny told you he bough a “liquid alt'“. What is he referring to?

Alternative mutual funds

“alternative mutual funds” are informally known as “liquid alternatives” or “liquid alts”.

Describe what “hard” and “soft lockup periods” are for hedge funds

Hard lockup period: redemptions are not allowed for any reason

Soft lockup period: redemptions are allowed but are subject to a redemption fee

what are “first-order risks”?

risks that are related to changes in the market

when an alternative investment portfolio manager aims to earn positive returns in all markets, what is this called?

Absolute returns

Additional Learning:

Alternative investments give the portfolio manager more flexibility in using strategies such as short selling to profit in down markets. Strategies such as these can allow the manager to potentially earn “absolute returns” (a positive return in all markets).

As an alter

With reference to hedge funds, what does the “lock-up period” refer to?

the time period during which initial investments cannot be redeemed from a hedge fund.

Additional learning:

hedge funds often employ riskier strategies, which can take time to be successful. As a result, some hedge funds require lock-up periods of three years of more! this allows the fund manager to focus on the long-term performance without having to worry about redemption requests.

Which investment product is more liquid, mutual funds or hedge funds?

Mutual funds

what is an “accredited investor”?

One way that investors can gain access to hedge funds is if they are considered an “accredited investor” by meeting the following criteria":

• net income before taxes of more that $200,000 (or $300,000 combined if married) in both of the past two years, or

• household (along or combined if married) net financial assets in excess of $1 million. “financial assets” include things such as stocks bonds, and cash.

the reasoning is that people with that much income or assets are able to manage the risks associated with hedge funds.

what do “relative value strategies” attempt to profit from?

“relative value strategies” attempt to make a profit by taking advantage of pricing or arbitrage opportunities