ALT INVESTMENTS midterm

*4 types of IRR*

*Lifetime*: contains all of the cash flows, realized or anticipated, occurring over the investment's entire life, from period 0 to period T *Since-Inception*: used as a measure of fund performance rather than the performance of an individual investment. terminal cash flow here is the appraised value of the fund's portfolio at time T *Interim*: based on realized cash flows from an investment & its current estimated residual value. can be calculated on an investment purchased subsequent to inception *Point-to-point*: a calculation of performance over part of an investment's life. calculated from one point in time to another point in time. all cash flows are realized or appraised values not expected cash flows over the investment's projected life

*Pros & Cons of Real Estate*

*Pros:* potential to..... - offer absolute returns (low correlation to stocks & bonds) - hedge against unexpected inflation - provide diversification w/ stocks & bonds - provide cash inflows -provide income tax advantages *Cons:* - heterogeneity: physical features of the individual properties are unique in terms of location, use, design, but varying lease structures can lead to large differences in income streams - lumpiness: indivisible nature of private real estate assets leads to problems with respect to large investment sizes and relatively high transaction costs - illiquidity: hard to buy & sell quickly

Which of the following is least likely to be a problem related to the return characteristics of *alternative assets*?

*absolute returns*

An investor who uses *arbitrage to earn investment returns* is most likely to use which of the following strategies?

*active absolute return strategy*

In a forward contract, what is the *difference between the spot price of reference asset and the price of a forward contract*?

*basis*

Which of the following is least likely a goal of alternative investing?

*benchmark returns*

The city planning board is converting its City Hall from a *government asset into being privately investable*. What type of project is this and what is one of the project's key characteristics?

*brownfield project* with cash flows generated in a monopolistic environment

brownfield & greenfield

*brownfield*: existing project that has a history of operations and may have converted from a government asset into something privately investable *greenfield*: a new yet-to-be-constructed project

An investor would like to obtain diversified exposure to commodities with limited downside risk. Which of the following commodity investments would be most appropriate for the investor?

*commodity-linked note*

Which term best describes the relationship between the spot price (S), and the price of a commodity futures contract F(T), in the equation S < F(T) ?

*contango*

Alternative Investments with *high levels of illiquidity* should earn:

*higher returns* than the return predicted by the CAPM

In studying the shape of a return distribution, what measure captures the fatness of a distribution's tails and a higher value indicates a higher likelihood of an extreme event?

*kurtosis*

The internal rate of return calculation for cash flows in which the first and last reported cash flows are appraised values is the:

*lifetime IRR*

What is the term for assets that are generally purchased and sold only in specific quantities due to the difficulty associated with dividing them into smaller quantities?

*lumpy assets*

Within the world of financial economics, what type of asset pricing model attempts to show how people and prices should behave?

*normative model*

*Normative vs Positive model*

*normative*: describes how people and prices ought to behave *positive*: describes how people and prices actually behave

The key *risk that residential mortgage-backed security holders must manage* is:

*prepayment risk*

Investments in which the underlying assets involve direct ownership of non-financial assets rather than the ownership through financial assets. This is known as:

*real assets*

Which of the following best describes the component of futures return that is earned as a result of the change in the contract's basis through time?

*roll return*

Which of the following statements regarding asset classes in economic conditions is most accurate?

*stock and bond prices* are based on expected future economic conditions, while *commodity prices* are based on current economic conditions

*alpha*

*superior risk-adjusted performance.* returns to any excess or deficient investment return after the return as been adjusted for the time value of money (the risk-free rate) and for the effects of bearing systematic risk (beta). refers to the extent to which the skill, info, and knowledge of an investment manager generate superior risk-adjusted returns (or inferior risk-adjusted return in the case of negative alpha).

*theoretical & empirical model*

*theoretical*: tend to explain behavior accurately in more simplified situations, in which the relationships among variables can be somewhat clearly understood through logic *empirical*: tend to explain complex behavior relatively well when there are many data points available and when the relative behavior of the variables is fixed or is changing in predictable ways

*intellectual property (IP)*

- *intangible asset* can be owned - can be viewed as being both excludable creativity and ownership rights to creations of the human mind - much of the value of the stocks and bonds of a modern corporation, such as a pharma firm or a computer tech firm - assets include: art, brands, patent portfolios, film copyrights, media content - may be constructed as the present value of expected future cash flows - the value at its creation is the sum of the discounted expected cash flows generated by the IP. - further assume that the property has *2 possible outcomes: the probability of generating large positive cash flows and the probability of generating no positive cash flows*

*Beta*

- *the proportion by which an assets excess return moves in response to the market portfolio's excess return* - beta has a more general interpretation outside the CAPM - beta refers to a measure of risk, or the bearing of risk, wherein the underlying risk is systematic (unable to be diversified or fully hedged without cost) and is potentially rewarded with expected return - beta can be used to *refer to any systematic risk* for which an investor might be rewarded - assets can have more than one beta. and a beta does not have to be a measure of the response of an asset to fluctuations in the entire market portfolio

cost of carry

- Any financial difference between maintaining a position in the cash market and maintaining a position in the forward market - spot commodity price + carrying costs = forward price

forward contracts

- OTC contracts not exchanged (no market prices, not standardized) - b/c they are specific to a given counterparts, transaction can only be closed with the same counterparty - to buy or sell at a specific price on future date - used for hedging - CUSTOMIZABLE to commodity, amount & delivery date - higher default risk

*Real Estate Investment Trusts (REIT)*

- REITs are publicly traded vehicles that allow retail access to an asset class (real estate) that is often considered to be an alternative asset class - they are an entity structured much like a traditional operating corporation, except that the assets of of the entity are almost entirely real estate - most major REITs are listed on major stock exchanges; they are a simple and liquid way to bring real estate exposure into an investors portfolio - owning/operating real estate generating income. REIT portfolio to diversify

contango

- When a future price is above the spot price - Caused by companies wanting to lock in future rates to match future liabilities - when asset price is expected to rise over time, resulting in an upward sloping forward curve - in Contango, investors are willing to pay more for a commodity at some point in the future. the premium above the current spot price is generally associated with the cost of carry.

*idiosyncratic*

- a type of investment risk, uncertainties and potential problems that are *endemic to an individual asset. INDIVIDUALIZED.* the opposite of idiosyncratic risk is a systematic risk - it is also referred to as a *specified risk* - ex. endemic to an individual asset (like a particular company's stock), or group of assets (like a particular sector's stocks), or in some cases, a very specific asset class (like collateralized mortgage obligations).

futures vs forwards

- both include agreement to buy/sell commodity at set price in future. - future traded on exchange, forward is OTC - settlement for forward takes place at end of contract, futures contract P&L is daily - futures exist as standardized contracts that are not customizable

*ex ante alpha*

- ex ante alpha is the *expected superior return if possible (or inferior return if negative) offered by an investment on a forward-looking basis after adjusting for the riskless rate and for the effects of systematic risks (beta) on expected returns* - ex ante alpha is generated by a deliberate over-allocation or under-allocation to mispriced assets based on investment management skill - simply put, ex ante alpha indicates the extent to which an investment offers a consistent superior risk-adjusted investment return - thus, ex ante alpha can only be estimated or predicted - a positive ex ante alpha is an expression of the belief that a particular investment will offer an expected return higher than investments of comparable risk in the next time period.

futures contracts

- exchange traded - high degree of uniformity w/ regard to quantity & quality - contracts that obligate the parties to transact an asset at the predetermined future date & price. buyer must purchase or seller must sell asset at set price regardless of current market price at expiration date. - can be used for hedging/trade speculation - lock in price of underlying asset/commodity - usually use high leverage

*infrastructure stocks*

- higher dividend yields and lower volatility than stocks from other sectors - the higher dividend yields from the relatively inelastic demand for infrastructure services - generally reduced growth potential for infrastructure assets compared to overall equities

*active passive spectrum*

- much of the asset management industry has moved into the tails of the alpha driver-beta driver spectrum - at one end of the spectrum are alpha drivers that seek new investment strategies offering superior rates of risk-adjusted return - at the other end are passive indexation strategies which offer beta exposure as efficiently as possible without any pretense of alpha seeking

commodity swap

- portfolio of commodity forwards - ex: rather than bear the risk of fluctuating oil prices, a refinery may decide to lock in purchase price of oil by entering various forward contracts to purchase oil at prespecified prices (swap cash for oil) -

commodity related equity

- price of common stock can be viewed as product of the earnings per share (EPS) and price-to-earnings ratio (P/E) - EPS of commodity producing firm may be highly correlated to the price of underlying commodity, P/E might not be -

*return smoothing* !!

- see if there is some flexibility on the valuation of the asset traded by funds - to create portable alpha products combining futures and absolute returns funds - boost the returns of monetary products - enables a fund to hide risk - less exposure to any extreme market ups and downs over time - smooth progression of investment growth & risk protection over time - lower risk of potential losses due to fear driven investing in and disinvesting in volatile markets - biases in estimates of abnormal performance and idiosyncratic volatility. - funds with high systematic risk, a standard deviation increase in smoothing implies an upward bias and a downward bias in equity market beta. - funds with low systematic risk exposure, smoothing bias most apparent in est.s of idiosyncratic volatility

*variable rate (mortgage)*

- the market value of a variable-rate mortgage (absent default) behaves like a money market account to the extent that the mortgage's rate adjusts quickly and without limits - an advantage to a lender is that it protects the lender from the valuation fluctuations due to interest rate changes experienced with fixed-rate mortgages - a disadvantage is the risk to the borrower that interest rates will increase - a variable-rate loan provides the advantage to the borrower of substantially lower initial interest rates

*ex post alpha*

- the return, observed or estimated in retrospect, of an investment above or below the risk-free rate and after adjusting for the effects of beta (systematic risk) - simply put, ex post alpha is *the extent to which an asset outperformed or underperformed its benchmark in a specified time period* - ex post alpha can be the result of luck or skill

*evergreen funds*

- unlisted open-end funds allow investors to subscribe to or redeem from these funds on a regular basis. - to fund net investor redemptions, an open-end fund must have the ability to liquidate assets, attract new investors, borrow on a line of credit, or draw down cash balances

*default risk*

- while fundamental analysis of residential mortgage default risk focuses on the *credit risk of the borrower*, fundamental analysis of commercial mortgage default risk focuses primarily on the role of rental income from the property in covering the mortgage payments - commercial borrowers then typically need a larger down payment or equity contribution than do borrowers purchasing residential real estate

Consider a fund with a 2.5% ex-ante alpha. Last year the fund outperformed the market by 3% and outperformed funds with similar risk by 4%. *What portion of the ex-post alpha was generated* purely by luck?

1.5%

Consider a fund that invests only in auto stocks. Recently it hired a skilled manager who selected a portfolio that was 2% underpriced but eventually underperformed by 2% with comparable portfolios due to an unexpected increase in the federal tax in the auto industry. *What were the ex-ante alpha and ex-post alpha* for the manager?

2% and -2%

exchange traded (funds/notes)

ETF = security that involves collection of securities (stocks, etc.) that often tracks underlying index. similar to mutual funds, but exchanged daily like stocks. holds multiple underlying assets. collection - when futures prices are in con tango, ETF prices are likely to underperform spot prices of the commodity ETN = purchase a debt security with cash flows that are directly linked to the value of a portfolio. incur the credit risk of issuing bank (i.e. counterparty risk). intermediate-term debt instrument whose value at maturity is a function of the value of an underly commodity or basket of commodities. opportunity to be fined w/ debt securities having coupon or principal payments directly related to the same commodity price that drives its rev

Jon Phillips is considering switching his investment portfolio to another firm that offers more investment options. Phillips just returned from a presentation by an investment advisory firm that offered separately managed accounts (SMA). *Which of the following statements regarding the benefits of SMAs is most accurate?*

SMAs promote individually tailored objectives while also offering transparency to the client

An analyst wanting to evaluate the *historical risk-adjusted performance* of a hedge fund manager should use:

a *time series, ex-post asset pricing model*

For several years a fund has smoothed the returns on its real asset investments before reporting the results to investors. Generally, the effect of *smoothing asset returns* is:

a lower standard deviation of returns

Which of these statements would best describe *how applied modeling offers from abstract modeling?*

applied models help address real-world challenges and abstract models explain hypothetical behavior

Real Estate Investment Trust *(REIT) prices and returns*:

are based on market prices rather than appraised values

How are *beta* driven products generally described?

as attempting to capture systematic risk premiums

Which of the following *statements about beta and alpha drivers is false?*

asset classes contain only an alpha driver or a beta driver

Mr. Mack is buying a home and after much comparison-shopping, he decides to go with an adjustable-rate mortgage rather than a fixed-rate mortgage. The loan has a 2% annual interest rate cap and an interest rate floor of 3.25%. This feature most likely:

benefits the lender

To *initiate arbitrage if the futures contract is overpriced*, a trader should:

borrow at the risk-free rate, buy the asset, and sell the future

Which of the following is not a way *commercial mortgages differ from residential mortgages*?

commercial mortgages typically contain fewer covenants, due to the greater sophistication of the borrowers

Which of the following best describes *commodity exposure to event risk*?

commodity returns tend to be positively skewed indicating unexpected events benefit commodity investors

*arbitrage*

concept: an active absolute return strategy pure arbitrage 1: attempt to earn risk-free profits thru the simultaneous purchase and sale of identical positions trading at different prices in different markets pure arbitrage 2: often used to represent efforts to earn superior returns even when risk is not eliminated

*Product innovators* are best described as investment managers who attempt to:

create new products with superior rates of risk-adjusted return

*internal rate of return (IRR)*

discount rate that equates the present value of the costs (cash outflows) of an investment w/ the present value of the benefits (cash inflows) from the investment. interpreted as the annual equivalent return on a given investment. BUT in fact, its a true indication of a project's annual return on investment only when interim cash flows can be invested at the actual IRR

An investor considering investment in a film must estimate the value of the investment. *The best method to value an intellectual property investment* such as this is the:

discounted cash flow model

*Capital Asset Pricing Mode (CAPM)*

efficiently priced assets wherein the *expected returns of all assets are directly and linearly related to their market betas* (measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors). collapses all of the potential complexities of investments into one simple assertion: *all investors fully diversify into the same portfolio of risky assets, the market portfolio, which defines the one and only systematic risk factor. the only way that an investment manager can consistently earn higher returns is by taking more market risk*

Which of the following sets of investment categories or products is MOST accurately described as being driven by *beta* rather than *alpha*?

enhanced index and 130/30 funds (130% long, 30% short)

*appraisal methods*

estimates of the current value of the asset (may differ from the prices that the asset would achieve if marketed to other investors)

*value-added real estate*

exhibits 1+ of the following: - achieve a substantial portion of their anticipated returns from appreciation in value - exhibit moderate volatility - does not have the financial reliability of core properties - includes: hotels, resorts, assisted care living facilities, outlet malls, hospitals, low-income housing

*limited partnerships*

focus on serving as intermediaries between investors & alternative investments. most US funds are LP & offer incentive based compensation to managers. (hedge funds, PE, managed futures funds, CTAs)

*sell side*

focuses on distributing securities to the public. they are agents for investors. in the primary market, dealer banks are intermediaries between issuers and investors, provide liquidity, and underwriters of investments. in secondary securities markets, large dealer banks trade with one another to facilitate trades

Which of the following statements regarding *forward and future contracts* is most accurate?

forward contracts contain substantially more counterparts risk

Which of the following *investment types of traded on an organized exchange*, thus offering a Central Market in *transparent pricing*?

futures contracts

Which of the following is *not a problem related to the appraisal-based nature of property indexes*?

high volatility

Smoothed return for an asset class such as real estate most likely results in:

higher risk-adjusted return measures

Which of the following statements regarding *normal backwardation and contango* is most accurate?

in normal backwardation, the futures price is below the expected future spot price

A common theme shared by *different asset pricing models* is that:

investors should expect to be paid for taking on systemic risk

*Asset pricing models* are helpful tools for separating total risk and investment into its:

non-diversifiable and idiosyncratic components

*normal distribution symmetry*

normal distribution is symmetrical. some alt. investments, however, can be highly asymmetrical and therefore require specialized risk measures focused on downside risks

*benchmarking*

performed by investors and analysts *external to an investment pool for the purpose of monitoring performance*. the risk & return on investment will have greater meaning if compared to the benchmark rather than analyzed in isolation

The *behavioral model* that predicts how investor's actions are affected by *psychological biases* that often lead to suboptimal behavior is best described as an:

positive model

*Positive & Negative Cash Flows*

positive: distributions from the investment to the investor negative: capital calls in which an additional capital contribution is required of each investor to the investment

An alternative investment analyst is examining a historical commodities markets index in an attempt to better understand the term structure of forward prices. Which of the following would be *indicative of a commodity market in contango*?

prices steadily increase in future delivery months

*master limited partnerships (MLPs)*

publicly traded investment pools. offer their owners pro rata claims. LP has limited liability but can't participate in management

Which of the following is a *disadvantage of timberland investments*?

recycling efforts may dampen the demand for timber products

*buy side*

refers to institutions and entities that buy large quantities of securities for the portfolios they manage. includes asset owners & asset managers

rolling contracts

refers to the process of closing positions in short-term futures contracts and simultaneously replacing the exposure by establishing similar positions with longer terms

Returns evaluated relative to a *benchmark* are:

relative return standard

Which of the following is a characteristic that can be used to help define what constitutes an alternative investment?

serve as *portfolio diversifiers*

*systemic risk*

some risk can be reduced/eliminated by diversification. risks that cannot be fully diversified away are systematic & should be rewarded w/ higher expected returns. ex. inflation, changes in interest rates, fluctuations in currencies, recessions, wars

A large client has had several future contracts hedging commodity risk. What happens if the *counterpart cannot perform its financial obligations* during the marking-to-market process?

the contract is settled at the time of non-performance and the exchange guarantees the transaction

Which of the following *will not increase the value of Farmland as an investment*?

the crop that is best suited to the property must be harvested in the short time window

What are the typical *implications to a REIT investor* of REITs being listed?

the investor enjoys higher liquidity but assumes an increase in systematic risk

A pension has a $20 million portfolio that is well-diversified. Which of the following statements about this portfolio is most accurate?

the portfolio likely contains *more systematic risk than idiosyncratic risk*

Which of the following would most likely make an *infrastructure investment non-investable*?

the project is short-term in nature

Which of the following statements regarding the *differences between separately managed accounts (SMAs) and investment funds* is most accurate?

unlike hedge fund investors, SMA investors may lose more than 100% of their original investment