CAIA Level II

actions resulting from monitoring

1. Actions within the fund's governance process: negotiate for lower management fees, early release from commitments, terminate fund management 2. Actions outside of the governance process: refuse follow-on commitment, limited partner default 3. Actions outside of PE investing: allocate to public, small-cap equities as a proxy to PE, co-investing

7 components of the investment policy statement

1. Background 2. Objective 3. Asset classes 4. Governance 5. Manager selection 6. Reporting and monitoring 7. Strategic asset allocation

primary differences between systematic global macro and CTAs

1. CTAs wait for established trend in prices while macro attempts to forecast price information to anticipate trends 2. CTAs focus on price only while macro considers many variables most of all fundamentals 3. CTAs follow homogeneous strategies, macro does not 4. CTAs primarily use momentum indicators, macro uses fundamental indicators

4 models for directional currency trading

1. Carry 2. Trend-following/momentum 3. Value 4. Volatility

4 primary hedge fund categories of cash

1. Cash for fund expenses 2. Cash for trading 3. Cash flow to and from investors 4. Unencumbered cash

3 real estate investment style

1. Core real estate - least risky; higher proportion of return comes from income rather than property appreciation; more liquid, less leverage, lower volatility; properties are well established and more developed; holding period is high to take advantage of income; rollover risk low 2. Value-add real estate - more risky, returns generated from income and property appreciation; properties are less well known and less developed; moderate leverage applied; holding period is moderate and rollover risk is moderate 3. Opportunistic real estate - most risky; returns generated mostly from property appreciation; more leverage and more volatile; properties require significant development e.g. raw land development; holding period is short since price appreciation is main source of return and rollover risk is high Styles are introduced in a portfolio: 1. To assess performance e.g. performance attribution 2. Detect style drift to assess riskiness of portfolio at points of time 3. Detect opportunities for diversification

4 categories of costs incurred by institutional investors

1. Costs related to the construction and management of the portfolio - these are direct and explicit e.g. management fees, performance fees 2. Costs associated with activity and portfolio transactions - these are often embedded (not explicitly charged) and undisclosed e.g. trading and brokerage costs, market impact costs (slippage), prime brokerage costs 3. Fund servicing costs - administrative/operational in nature e.g. custody, audit, legal, administrative fees 4. Investment oversight/monitoring costs - includes overhead and ongoing oversight and monitoring costs e.g. staffing costs, IT, brokerage wrap fees, consultant fees, FoF fees

tax benefits of real estate

1. Depreciation tax shield 2. Tax deferral 3. Leverage - interest deduction and magnification effect of depreciation tax shield

asset allocation process

1. Determine the asset owner's objectives (stated in terms of risk and return and often evaluated with utility functions) and constraints 2. Specify the asset allocation approach 3. Implement the asset allocation determined by the investment policy statement 4. Allocate capital 5. Monitor and evaluate investments

motivation to invest in farmland

1. Diversified return source - no direct links to financial markets as it is held privately, subsidized by government, and subject to idiosyncratic economic dynamics 2. Inflation hedge - inelastic supply curve (finite source) and linked to energy and food production 3. Favorable exposure to energy, food, and water - demographic and economic trends expected to create demand for agricultural products which will result in rising prices for farmland

Private equity ODD process

1. Document collection 2. Document analysis 3. On-site visit 4. Service provider review 5. Investigative due diligence 6. Process documentation 7. Operational decision 8. Ongoing monitoring

benefits of co-investment

1. Enhanced return relative to primary strategies 2. J-curve mitigation (no 2/20, less un-invested capital) 3. Higher efficiency in terms of desired risk exposures 4. Tailored portfolios 5. LPs develop investment selection skill

PE relationship life cycle

1. Entry and establish phase 2. Build and harvest phase 3. Decline or exit phase

investigative due diligence models

1. Equity ownership model - investigations performed on all equity owners (partners) 2. Investment decision-making athority model - portfolio managers, traders, others with investment authority 3. Risk control model - both investment and noninvestment personnel who control risk

three global macro schools of thought

1. Feedback-based managers - try to understand and interpret the market's psychology and attempt to take advantage of market irrationality i.e. contrarian view is applied 2. Information-based managers - gather and analyze information at the micro level to better understand the macro picture 3. Model-based managers - rely on financial modeling and underlying economic theories of fiscal and monetary policies to place bets; use carry trades, yield curve RV, currency RV via PPP, valuation models, option pricing models

costs of actively managing alternative investments

1. Foregone loss carryforward 2. Lack of interest received on cash balances 3. Lack of excess returns 4. Administrative costs 5. Liquidity costs

performance persistence challenges

1. How to define top performance 2. Sill or luck? 3. Are the comparisons apples to apples? e.g. same market conditions? same vintage? 4. Secular market trends - skill or bull market effect? 5. Skill or fund size effect? 6. Statistics tied to different PE market niches

5 benefits to commodity futures allocation

1. Improved risk and return profiles of portfolios due to low correlation with stocks and bonds 2. Ability to hedge inflation, business cycle, and event risk 3. Improved performance through the diversification return due to mean reversion of commodity prices 4. Potential for positive risk premium and roll return 5. Positively skewed return distributions (positive exposure to event risk)

5 action areas to transition to long-term investing

1. Investment beliefs - express the long-term investment philosophy of the investor and provides a sustainable foundation for long-term investing; a compass that guides 2. Risk appetite statement - clarifies risk appetite of asset owners 3. Benchmarking process - measures investment success over the long-term; should distinguish between the long-term investment strategy and the asset manager's execution of that strategy 4. Evaluation and incentives - evaluation and incentive framework should support long-term value creation and should align asset owners' and managers' interests 5. Investment mandates - contract between asset owner and manager that formalizes the long-term approach and aligns the interests of asset owners and managers, thereby reducing principal/agent conflicts

4 primary forms of PE intermediation

1. PE funds 2. PE FoF 3. PE funds with co-investments 4. Direct investments in PE FoF are the most common institutional investment program type.

3 approaches for accessing hedge funds

1. Self-managed approach - direct investment 2. Delegated approach - FoFs 3. Indexed approach - replicating the performance of a hedge fund index by seeking an FoF or other financial product that attempts to mimic the performance of the index

drivers of agricultural productivity

1. Specialization - intertemporal crop rotation vs. monocropping 2. Extensification - increasing or decreasing land use 3. Intensification - additional inputs that lead to greater outputs

sources of return for commodity futures contracts

1. Spot return 2. Collateral yield 3. Roll yield - return realized from the change in the basis over time, realized when rolling contracts over at maturity; positive in backwardated markets and negative in contangoed markets; influenced by the convenience yield and thus the shape of the commodity term structure

types of sovereign wealth funds

1. Stabilization funds to smooth volatility in government revenue and spending; acts as a countercyclical vehicle; deposits are rules-based; invests primarily in cash and fixed-income instruments for capital preservation 2. Savings funds to benefit future generations; goal of preserving and growing wealth, typically in the face of a depleting export revenue source e.g. oil; invests substantial amount in equity and alternative assets to grow capital 3. Reserve funds to meet specific future liabilities; two types: pension reserve and reserve investment fund (mandate to invest in a country's infrastructure and economic development); invests substantial amount in equity and alternative assets to grow capital 4. Development funds to promote economic diversity in the economy, developing strategic industries, and alleviating poverty; often focused on domestic investments and earn substantial illiquidity premia from concentrated positions and alternative assets including private equity and venture capital

guiding principle to minimize agency costs

1. Stakeholders must discuss and agree on a set of investment beliefs that are actionable 2. Stakeholders must clarify issues surrounding risk such as risk tolerance and risk measurement 3. Stakeholders must agree on an investment mandate that formally aligns the interests and behaviors of all relevant parties but especially asset owners and managers 4. Asset owners and managers should discuss and agree on evaluation and performance measures that are consistent with long-term value creation

3 primary types of credit risk models

1. Structural models - values assets as equal to the value of equity plus debt; considered structural because draws a relationship between credit risk and capital structure; best suited for fundamental credit analysis; weakness is that assumptions may not hold in the real world; best known model is the Merton model 2. Reduced-form models - views default as a random (exogenous) event that can be quantified using economic and statistical models; no emphasis on capital structure; used to determine unconditional and conditional probabilities of default; strength is that models are flexible and simpler to implement, best used in derivatives trading; weakness is that it ignores fundamental drivers of credit risk; best known models are Jarrow-Turnbull and Duffie-Singleton models 3. Empirical models produce a credit score from regression analysis of historical data: relative measure of credit risk determined by a range of firm-specific characteristics (liquidity, profitability, leverage, activity) and sensitivities to those characteristics; does not attempt to model default or credit spreads; best known model is Altman's Z-score

commodity futures curve theories

1. Unbiased expectations hypothesis - the futures price is an unbiased predictor of the expected future spot price; holds only if markets are risk-neutral 2. Liquidity preference hypothesis - term structure shape determined by pre-dominance of hedger type: either producer or user. Producers prefer longer-dated contracts while users prefer shorter-dated (spot) contracts. To clear the markets producers must accept a discounted futures price from users. This price is lower than the expected future spot price leading to normal backwardation in commodity markets. Net effect is a shortage of long futures positions. 3. Storage models - consider the impact that current and expected storage levels have on convenience yield and thus spot and futures prices; storage models generally forecast upward (downward) sloping forward curves when inventory levels are above (below) demand. 4. Preferred habitat hypothesis - producers have different maturity preferences based on their cost structures

mean-variance optimization issues

1. Unrealistic weights unless short-selling is allowed --> "error maximizer" 2. Alternative assets have infrequent data and are illiquid --> results in smoothed returns which underestimates variance and covariance 3. Relies only on mean and variance while ignoring higher moments of the distribution 4. Output very sensitive to changes in the mean, variance, and covariance

forms of market efficiency

1. Weak form efficiency - prices reflect all available market data --> positive returns not sustainable using technical analysis 2. Semistrong form efficiency - prices adjust to reflect all publicly available information --> positive returns not sustainable using fundamental analysis 3. Strong form efficiency - prices reflect all information, both public and nonpublic --> positive returns not sustainable

PE fund categorizations

1. blue chip 2. established 3. emerging 4. reemerging

characteristics of distressed debt

1. credit rating of CCC or lower 2. trading at 40% of par or lower 3. spread of 1,000 bps or higher against UST 4. price of equity is 0 or very near 0

5 factors limiting arbitrage

1. fundamental risk 2. noise traders 3. leverage risk 4. market frictions 5. agency relationship

key PE risks

1. market risk - the uncertainty regarding estimating and establishing a price for an illiquid asset. Specifically, it is the risk that price may not be aligned with intrinsic value 2. liquidity risk - asset may not be able to be sold quickly without a significant loss in value. Small and inefficient secondary market makes liquidity risk high in PE 3. commitment (funding) risk - relates to the unpredictable nature of capital calls. Investors may default if they cannot produce funds to meet a capital call 4. capital (realization) risk (not recovering invested capital)

intellectual property

2 types: 1. Unbundled IP - technology and inventions separate from its parent corporation; stand-alone IP; potentially very risky but profitable 2. Mature IP - fully developed IP and its usefulness to the market has been established; cash flows are more stable and predictable and valuations more certain e.g. motion picture already in distribution

risk management of a defined benefit plan

3 approaches: 1. Asset-focused risk management: considers only the risk of plan assets 2. Asset-liability risk management: focuses on the surplus of plan assets over liabilities (low risk assets are those with negative correlation to liabilities as the goal is to maximize the surplus) 3. integrated asset-liability risk management: integrates surplus management with the operations of the plan sponsor 4 key factors that affect risk of plan liabilities: 1. Interest rates 2. Inflation 3. Retirement cycle 4. Mortality A plan sponsor needs to consider 5 key factors in addressing its risk tolerance: 1. Funding status of the plan 2. Size of the fund 3. Expected future contributions 4. Sponsor's general financial position 5. Participant demographics

PE cash flow modeling

4 advantages to modeling PE cash flows: 1. Increasing the profit generated via overcommitments 2. Improving investment returns for undrawn capital 3. Calculating an economic value assuming a specific discount rate (at portfolio level) 4. Monitoring the risk/return profiles and cash flows for a portfolio of funds 3 formal approaches to modeling PE cash flows: 1. Estimates (3-6 month horizon) 2. Forecasts (used for a 1-2 year horizon) 3. Scenarios (2 years and beyond) Forecasts represent the most likely outcome while scenarios represent a set of possible situations that help investors manage uncertainty in the long-term.

volatility hedge funds

4 subcategory of volatility hedge funds: 1. Relative value - take positions in implied or realized volatility using quantitative or fundamental models 2. Short volatility - earn positive risk premia from shorting vol; suffer losses when vol increases 3. Tail risk - perform wel when the markets are stressed and incur small losses during normal markets due to time decay; take long and short positions 4. Long volatility - perform similarly to tail risk hedge funds but return profile not as smooth because don't short vol; provide most direct form of tail risk hedge but costly (largest performance drag)

PE liquidity

5 sources of liquidity for meeting capital calls: 1. Distributions from PE investments 2. Maturing treasury investments 3. Realizations from other investments 4. Liquidity lines 5. Selling off LP shares (secondary market) 6. LP default (last resort) Two forms of illiquidity risk for PE investors: 1. funding risk - an inability to meet capital calls 2. exit risk - inability to liquidate an investment at a specific time and price

5th percentile vs 25th percentile performance

5th percentile managers outperform in every comparison BUT 25th percentile managers' performance is more volatile --> even if 25th percentile managers outperform they tend to mean revert --> demonstrates the perils of choosing managers based on historical performance

exchange rate risk on commodities

A general depreciation of the USD increases the price of dollar-denominated commodities e.g. oil, since exporters demand higher prices to compensate for the loss in return in local currency terms

crop yield

A measure of agricultural productivity (units produced per unit of land) over a period of time and is a product of solar radiation, amount of solar radiation captured by crop canopy, photosynthetic efficiency of the crop, and the harvest index (total dry matter that can be harvested)

cash flow at risk (CFaR)

A more appropriate measure of risk for illiquid assets with long time horizons like private equity. Represents the max deviation between a budgeted level and actual cash flows for a given confidence level within a given period

REIT

A public real estate investment. To be classified as a REIT and allow investor income to enjoy pass-through benefits (no double taxation as dividends are deducted from income when determining corporate tax liability), 75% of income must be received from real estate activities and a minimum 90% of the income produced passed through to investors

meta risk

A qualitative risk that is not captured by specific, measurable financial risks. Meta risks are a catchall category as they represent risks that do not fit into another specific operational category but must still be accounted for. They are subjective in nature and will vary in importance based on the individual investor evaluating them e.g. behavioral biases, moral hazards, over-reliance on quantitative tools, the challenges of market complexity

absolute return vs. relative return

Absolute return standards evaluate investment returns against a standard of zero or the risk-free rate. The point is to earn a return in any market environment. Relative return standards evaluate investment returns against a benchmark return with the goal of consistently outperforming that benchmark.

advantages and disadvantages of investing in real estate

Advantages: 1. Provide absolute returns 2. Hedge against unexpected inflation 3. Improves portfolio diversification 4. Provide cash flow (income_ Disadvantages: 1. Properties are heterogeneous --> wide variance in returns 2. Investments are lumpy (cannot reduce size of ticket to match investor needs) 3. Illiquid

risk parity

Allocates weights of asset classes in a portfolio in such a way that each asset class contributes the same percentage of risk to the portfolio. Steps: 1. Define a unit of measure of risk 2. Measure incremental risk contribution of for each asset class 3. Determine the appropriate weights for each asset class The key takeaway is that asset classes with lower risk will have higher weights when the risk parity approach is applied.

endowment model

Also known as the Yale model. Considers the need to meet high return targets in order for the endowment to exist into perpetuity. High return targets are met by allocating a large portion of the portfolio to alternative investments. Corporate and foreign fixed income investments are rarely used. Empirical evidence suggests large endowments earned substantially higher returns than domestic equity and fixed income. 6 reasons why large endowments have outperformed: 1. Aggressive TAA 2. Superior investment manager research 3. First-mover advantage 4. Access to a network of talented alumni 5. Acceptance of liquidity risk 6. Sophisticated investment staff and board oversight Inflation risk is increasingly hedged by investing in real assets, particularly real estate and natural resources. Endowments are able to handle substantial liquidity risk and earn a large positive illiquidity premium --> liquidity management is critical Endowments can avoid liquidity issues by: 1. Stagger allocations to private equity and real estate funds over several years rather than one large commitment in a single year 2. Seek further gifts/donations 3. Borrow funds for short-term needs 4. Consider reallocating from less liquid to more liquid alternative investments

preferred return

Also known as the hurdle rate, the rate of return above the capital invested that the GP must achieve before participating in the profits i.e. before earning carried interest. Usually an annual compounded amount that will be at or below the historical return for public equity. In the U.S. the standard preferred return is 8%

risk factor investing

Approach that assumes that asset returns are determined by other risk factors in the market other than market risk (beta). 1. Assets are simply tools to gain access to risk factors. Assets themselves do not matter. 2. Most asset classes encompass multiple factors therefore risk premiums of asset classes are the sum of multiple risk premiums. 3. Investors should focus only on the risk factors relevant to her portfolio and optimize exposure to that risk factor Features of risk factors: 1. They are independent and therefore the size of risk premiums differ 2. Risk premiums from the same risk factor are not constant over time (over the business cycle) Considerations: 1. No benchmark for a passive factor investing strategy 2. Passively managed factor portfolio unlikely to exist

climate change strategy time frame

Asset owners should: In the short-term, integrate low-carbon solutions and avoid high-carbon companies In the medium-term, engage with policy-makers and companies In the long-term, integrate climate change investment in portfolio decisions

transaction-based index

Based on reported prices in real estate transactions Employs the repeat-sales method (uses returns from an asset that has undergone at least two transactions and applies to all properties) or hedonic pricing method (regression method that uses observed transaction data from dissimilar properties to discretely value property attributes and estimate prices of all properties, even for those that did not undergo a transaction, powerful inferential tool) Transaction-based index suffers from sample selection bias The S&P/Case Shiller index is a transaction-based index NCREIF Transaction-based Index utilizes the hedonic pricing model but also uses the appraisal values from the NPI

benchmarking process

Benchmarks measure investment success and should facilitate long-term, sustainable performance A strategy benchmark is used to measure the success of an investment strategy and should communicate the expected risk-return profile of the chosen strategy, determine whether the strategy achieves long-term success, and communicate relative success to key stakeholders; does not have to be investable e.g. absolute return target like cash + x%, blended index; strategy benchmarks encourage managers to focus on superior, long-term results An execution benchmark represents a low-cost means of executing an intended investment strategy against the mandate and determines how much value an active manager produces and determines his/her incentive compensation e.g. fundamentals based indices, quality indices

business cycle and commodity prices

Business cycle impacts commodity prices through: 1. central bank monetary policies 2. supply and demand changes 3. currency movements 4. Interest rate changes Lower interest rates increase commodity prices in the short run: 1. Lower real rates reduce the opportunity cost of storage --> increases the demand (and reduces the supply) of storable commodities, resulting in higher prices 2. Commodity prices tend to have positive inflation beta (move with inflation). Expansionary monetary policy to combat low demand and disinflation via lower rates will stimulate inflation and also stimulate commodity prices Overall, interest rate effects are most prevalent with agricultural and livestock commodities so they are a more effective business cycle hedge (demand is inelastic) while inflation effects are most prevalent with exhaustible commodities such as energies and industrial metals so they are a more effective inflation hedge. Commodities and equities have opposite performance during the phases of the business cycle, but perform similarly across a business cycle --> commodities can potential diversify against systematic risk 1. Early expansion: long stocks, short commodities 2. Late expansion: short bonds, long commodities 3. Early recession: short stocks, long commodities 4. Late recession: long bonds, short commodities

fund of fuds (FOFs)

Can be grouped based on objective and diversification approach: 1. Diversified FoF - 30-50 funds to gain diversification benefits 2. Concentrated FoF - 5-10 hedge funds 3. Single strategy - invests in 5-15 funds with a similar strategy 4. Tactical - invests in 5-10 funds to target specific market factors 3 ways FoFs add value: 1. Strategic allocation 2. Tactical allocation 3. Fund selection Advantages of FoFs: - Expertise and informational advantage - Manager access - Due diligence - Monitoring and evaluation - Immediate exposure - Improved diversification - Economies of scale and accessbility - Reduced (negotiated) fees - Education, partnership - Currency hedging - Leverage Disadvantages: - Double layer of fees - Lack of control over program - Inability to customize portfolio - Less transparency - Netting risk - Coinvestor risk (cash flow effects of other investors redeeming) - Administrative delay risk Returns lower, standard deviations higher, Sharpe ratios lower for FoFs in the period 2000-2014 than in the period 1990-1999 --> decline in performance Alternative weighting schemes to AUM-weighted approach: 1. Equal weighting 2. Equal risk-weighting (using inverse annual standard deviation) 3. Mean-variance optimization 4. Constrained mean-variance optimization (constraints on portfolio weights, higher moments)

managed futures strategies

Can be subdivided into 4 core dimensions: 1. Data sources: technical or fundamental 2. Style: discretionary or systematic 3. Strategy: momentum, mean reversion, global macro, relative value, carry, multistrategy 4. Time horizon Earn positive profits by: 1. Allowing market participants to hedge by taking opposite positions (mean reversion) 2. Offering liquidity to market participants 3. Assisting in rebalancing needs by taking offsetting positions Benefits: - Diversification; crisis alpha - Enhanced risk-adjusted perfomance - Access to multiple markets - Transparency - Liquidity - Capacity Methods of risk allocation: 1. Equal dollar risk 2. Equal risk contribution 3. Market capacity weighting With trend-following strategies the many small losses that result in drawdown are more than offset by gains that are large but fewer in number. Net effect is positive skewness and a payout profile that is convex. Returns appear to be analogous to a long straddle position but are actually the result of a long gamma position achieved by dynamic trading. CTA performance may be stronger during periods of market stress (crisis alpha). This is possible because CTAs invest in many liquid futures markets that do not suffer from illiquidity during periods of market stress. Volatility and market inefficiency during market stress are conditions that allow CTAs to earn excess profits during crisis. 3 primary sources of crisis alpha: 1. Trading in highly liquid markets minimally impacted by crisis 2. Take beneficial directional positions in multiple asset classes e.g. long winners, short losers 3. Trade financial futures, no short sale restrictions 3 types of benchmarks: 1. index of long-only futures contracts - CTAs short so not a good approach 2. Peer groups - most common but difficult to access data and lack of investibility; best for discretionary CTAs 3. Passive indices of futures trading e.g. MLM; best for systematic trend-following

commodity indices

Commodity indices can be value weighted (fixed value, fluctuating contract number) or quantity weighted (fixed contract number, fluctuating value weights). Rolling scheme (position on the forward curve and roll procedure) and weighting methodology (by liquidity, open interest, production, trade volumes) determine index performance. 1st generation indices: generally have long-only front month contracts rolled into second-month contracts without regard to the shape of term structure (contangoed markets significantly hurts performance) 2nd generation indices: seeks to improve index performance through enhanced roll techniques 3rd generation indices: applies more active contract and weighting selection to determine optimal composition of index; criteria include momentum, term structure, rules-based approaches 4 key measures of commodity index returns" 1. Excess return - percentage change in index before adjustments made 2. Spot return - percentage change in index after adjustments are made 3. Realized roll return: excess return less spot return 4. Total return: spot return + realized roll return + risk-free rate or --> excess return + risk-free rate NOTE: Index adjustments are a result of rolling over contracts and weight rebalancing. In the absence of index changes, excess return and spot return are equal and the realized roll return is 0.

performance persistence

Concerns the linkage between past results and future performance. From 1984 to 2011 persistence existed for VC and up until 2000 for most PE strategies including buyout funds but since 2011 persistence is not evident.

Infrastructure assets

Considered defensive investments because they have low exposure to fluctuations in economic cycles 1. Less sensitivity to economic cycles 2. Natural monopoly positions 3. Regulated entities have stable prices (government floor and ceiling) 4. Stable cash flows, stable and high dividend yields 5. Cash flows that can be indexed to CPI 6. Long-term in nature

4 determinants of institutional investors' costs

Cost structure influenced by: 1. Policy portfolio - baseline asset mix that reflects long-term risk and return views 2. Portfolio size - larger portfolios tend to be more complex and thus more expensive 3. Investment vehicles - active vs. passive, separate vs. comingled accounts, limited partnerships, direct investing vs. fund of funds 4. investment model - traditional consultant model, internal CIO model, fund of funds model, outsourced CIO model (OCIO model tends to be less expensive than the traditional consultant model or the ICIO model) The traditional consultant model becomes less efficient as the portfolio grows in size and complexity (consultants meet few times per year, are generally more hands off) BUT internal CIO model is prohibitively expensive for most mid-sized institutions --> mid-sized institutions choose FoF model or OCIO model (which could be a FoF or consultant)

distributed ledger technology (DLT)

Electronic ledger of transactions based on cryptography reconciliation that effectively creates a trustless proof mechanism that facilitates transactions replaces the traditional transaction settler - a third-party commercial bank - with a non-traditional third party, miners, who validate the authenticity of transactions --> transactions are disintermediated and made more cost efficient, faster, and less prone to errors

nature of agricultural demand

Expected to continue to grow because: 1. Expanded non-food use of products in goods and processes especially in biofuels due to rising fuel prices, governmental policies to diversify away from fossil fuels 2. Higher incomes in EM leading to higher demand for meat-based proteins which results in higher demand for feed grains --> increased demand for farmland 3. Increases in global population overall

commodity calendar spread

Exploits trading opportunities across the time dimension. Takes long and short positions for different delivery times based on expectations of how the basis will change. Can be categorized as bull spreads or bear spreads: 1. Bull spread - Takes a long futures position in a short-term contract and a short position in a longer-term contract. In a contangoed (backwardated) market, the trade is profitable if the spread i.e. basis narrows (widens). Losses on bull spreads are limited to the cost of carry 2. Bear spread - Takes a short futures position in a short-term contract and a long position in a longer-term contract. In a contangoed (backwardated) market, the trade is profitable if the spread widens (narrows). Losses on bear spreads are potentially unlimited

total risk

For institutional investors with liabilities e.g. pension, standalone risk doesn't matter as much as relative risk: portfolio asset risk relative to liabilities Total risk is the volatility of the difference between the present values of portfolio assets and liabilities; the difference between the two is known as the funding status --> total risk is the volatility of the funding status

Section 1256 contracts taxation

Hybrid taxation regime (applies both the long-term and short-term tax to gains) that applies to futures contracts: 60% of gains taxed at the long-term rate (20%) and 40% at the short-term rate (39.6%) --> this 60/40 split is applied regardless of the actual holding period of the futures contract

commodity arbitrage

If futures contract is overpriced (basis is too wide): cash and carry arbitrage - Short futures contract (obligation to sell in the future), borrow at the risk-free rate, take proceeds from loan and purchase commodity in the spot market, deliver against short position at contract expiration with commodity purchased at spot, repay risk-free rate If futures contract is underpriced (basis is too thin): reverse cash and carry arbitrage - Buy the forward contract (obligation to buy in the future), sell short the commodity in the spot market, take proceeds and lend at the risk-free rate, once at contract maturity take delivery of commodity and cover short position

asset allocation versus security selection

In a well diversified portfolio, performance is significantly impacted by asset allocation and minimally impacted by security selection. The opposite is true for concentrated portfolios --> in a concentrated portfolio performance is mostly determined by security selection Does active management add value? 1. 90% of variability in pension fund returns was determined by asset allocation, with the remaining 10% determined by active management. 2. Evidence has shown that active management has little impact on portfolio return as 65% to 85% of mutual and pensions funds have underperformed their benchmark. Studies have shown that the asset allocation of well diversified portfolios determines 85 to 90% of the volatility of returns.

extensions to mean-variance optimization

In addition to optimizing along mean and variance, other dimensions to optimize along include: 1. liquidity (applying a penalty to utility of a security based on its degree of illiquidity) 2. factor exposure (applying a constraint to exposure level to certain risk factors) 3. estimation error (applying a reduction to the mean return to account for estimation error e.g. robust optimization

intergenerational equity

Intergenerational equity refers to balancing current spending needs with maintaining sufficient funds to support future spending needs. A low current spending rate benefits future beneficiaries and a high current spending rate benefits current beneficiaries.

7 long-term investment beliefs

Investment beliefs provide investors with a consistent way of thinking about markets, help investors design processes that are consistent with long-term value creation, make it easier for managers to focus on long-term fundamentals, and can be used to devise incentives that are conducive to a long-term mindset 1. Focus on the economic fundamentals not short-term price moves 2. In the short-run prices trend and deviate away from intrinsic values 3. Markets price information in the news, not long-term trends but prices revert to fundamentals 4. Long-term risk of loss (permanent impairment of capital) more important than short-term volatility 5. Diversification in the traditional sense does not necessarily work in a long-term portfolio - differences in the risk-return profiles across asset classes must persist long-term 6. Long-term investors benefit from investment action without short-term pressures 7. Long-term relationships between asset owners and managers foster higher, more sustainable returns

risk and return preferences

Most common way of expressing the choice between risk and return is expected utility. Utility is determined by the relationship between risk and return which is represented by the degree of risk aversion. As risk aversion increases, investment variance has an increasingly (linear) negative effect on expected utility.

central bank reserve accounts

National governments hold their sovereign wealth in the form of foreign currencies managed by their central banks and referred to as its reserve account. These reserve account is affected by the flows of currencies that occur as a result of international trade and capital flows. change in reserve account = change in current account + change in capital account

benefits of private equity secondaries

On a stand-alone basis: 1. Higher visibility into the composition and performance of the underlying portfolio --> lower blind pool risk 3. Lesser J-curve effect (because uninvested capital isn't a portfolio drag) 4. Lower loss rates and less return volatility 5. Access to funds or GPs that would not have been accessible otherwise Benefits of including in a PE portfolio: 1. Quicker build-up of a diversified private equity portfolio 2. Adds diversification to PE portfolio 3. Smoother cash flow profile because investments have shorter remaining lives Compared to traditional PE funds, PE secondary funds have: 1. higher average IRRs 2. lower TVPI ratios 3. lower loss rates 4. faster return of cash 5. less volatile returns

3 primary methods of hedge fund replication

Overall decline in alpha since 2001 and most recently the value is 0. 1. fund bubble hypothesis - average industry returns depressed because of increase in less-qualified managers 2. capacity constraint hypothesis - alpha is fixed to capacity and as AUM grew, became more difficult to produce 3. Increased allocation to active funds hypothesis 3 methods of hedge fund replication: 1. Factor based approach - based on the underlying assumption that asset-based factors can explain a significant amount of a fund's returns; create a portfolio of risk factors whose payoffs match the return of the benchmark 2. Payoff-distribution factor - create a portfolio with a return distribution that matches te benchmark; empirical studies show approach is successful in matching higher moments of certain strategies but mean returns are always lower 3. Algorithmic approach - systematize well-defined rules-based trading strategies e.g. merger arb, convertible arb, momentum

J-curve

Path of IIRR over the life-cycle of a PE fund that follows the shape of a J, with negative rates of return in the early periods followed by positive rates of return in the later periods up to fund liquidation. The negative returns during inception and the early periods are a result of the value drag from the accumulation of set-up costs and management fees while capital is still un-invested (GP searches for portfolio companies). The period of negative returns is generally lower for buyout funds than for venture capital.

tactical asset allocation (TAA)

Refers to investors placing more emphasis on asset classes that are expected to outperform in the near-term, perhaps taking advantage of market inefficiencies. Three characteristics of sound TAA model development are: 1. Use of economically meaningful signals 2. Absence of data mining 3. Avoidance of overfitting

convertible arbitrage

Relative value strategy with the objective of profiting from arbitrage opportunities arising from the mispricing of a company's convertible bonds and equity shares. Starting point is to buy company's convertible bond and short equity shares so as to be delta hedged. This achieves a market neutral position (directional risk hedged) but allow for upside potential from convertible bond. Convertible bonds are systematically underpriced as issuers are typically unable to raise capital through vanilla bonds as they have low cash flows and low credit ratings and instead must 1) incorporate an equity stake 2) underprice offering to bring in investors Terms: - conversion ratio: number of shares to be received upon conversion of bond - conversion price: represents price of each share --> par value / conversion ratio - convertible market price: quoted price of bond stated as a percentage of par - parity: current market price of shares x conversion ratio - conversion premium: % difference between convertible bond price and parity 4 stages of convertible bond behavior (conversion premium progressively decreases): 1. Distressed or junk: stock price low and far out of the money, company is considered distressed 2. Bond-like or busted: option is out of the money 3. Hybrid: option is ATM or near moneyness and option has value 4. Equity-like: option is in the money 5 components of return: 1. (+) Coupon payments and face value 2. (-) Equity dividend payments 3. (+) Rebates on short interest 4. (+) Arbitrage returns 5. (-) Leverage costs

appraisal-based index

Rely on estimated property values derived from sales comparison approach (sales price of comparable assets in area), the income approach (DCF), or the cost approach (estimates replacement cost of property) Advantages include no sample-size issues and appraisals can be conducted frequently Disadvantages include stale appraisal values, smoothing leading to understated volatility and correlation, and the need for current values for comparable properties NCREIF Property Index (NPI) is a value-weighted, quarterly, appraisal-based index. Gathers price data from members who are institutional real estate investment managers

Bailey criteria

Represent properties or characteristics that an appropriate investment benchmark must have in order to be useful: 1. Investable 2. Appropriate 3. Known/unambiguous 4. Measurable 5. Reflective of current investment options 6. Specific in advance (before money is managed and manager is evaluated) 7. Owned (buy-in from both manager and asset owner)

smoothing

Results when old or stale prices are used to estimate an asset's value or create an index. Results in positive first-order autocorrelation, lower estimated volatility and lower correlations with other asset class, and thus higher risk-adjusted returns 4 primary reasons: 1. Old or stale prices are used to value asset or create index 2. Professional appraiser may observe prices on a delayed basis or may be subject to anchoring 3. Current prices may signal lagged price responses (host of behavioral and structural phenomena e.g. anchoring) 4. Delay in setting a price in a transaction and reporting that price or prices may be set months ahead of transaction close

film returns

Similar to venture capital, most films generate little to no profit while very few generate exceedingly high profit --> returns are asymmetrical Academics have adopted the fat-tailed stable Paretian distribution and the four-parameter kappa distribution to mimic the uncertainty and fat tails of movie returns

FLOAM

States that a manager's ability to produce risk-adjusted alpha as measured by the information ratio (IR) is a function of the manager's skill in predicting security returns (information coefficient, IC) and the number of independent bets the manager takes (breadth). Extended FLOAM adds the transfer coefficient (TC) to account for restraints that prevent the manager from fully applying her skill: IR = IC x breadth^0.5 x TC There is a negative correlation between information coefficient and breadth. The number of stocks for which a manager can accurately predict returns for falls. It is easier to predict returns for whole asset classes rather than individual securities --> generally, there is a higher information coefficient for asset classes than there is for single stocks

3 steps and 3 decisions/3 overarching strategies in developing a climate change strategy

Step 1. Measure - quantifying portfolio exposure to high-carbon/high emission investments Step 2. Act - Influencing all key stakeholders to become involved in the process Step 3. Review and monitor - periodically evaluate strategy's effectiveness Decision 1 - Engaging companies (lobbying for corporate strategy that reduces high-carbon and high-emission activities) and policymakers (lobbying for carbon pricing/taxation that encourages substitution, incentives to transition away from fossil fuels, and research funding) Decision 2 - Investing in low-carbon investments e.g. low-carbon indices, ESG funds, green infrastructure Decision 3 - Avoiding high-carbon investments

strategic asset allocation (SAA)

Strategic asset allocation attempts to meet the long-term asset allocation goals while optimizing risk and return. To start the SAA process, asset owner must take a macro view of the economy for a specific period of time --> this view must incorporate expected risk and return for asset classes. Expected asset class return = short-term real riskless rate + expected inflation + asset class risk premium

property total return swap

Swap whereby the buyer of the property exposure pays a fixed price annually over the life of the swap in exchange for the return on an underlying real estate index (the floating leg). A real estate investor who is concerned about a downturn in the real estate market can hedge property holdings by selling property exposure (and receiving a known, fixed payment) without having to sell the actual property

dynamic asset allocation

The asset allocation strategy chosen will determine a portfolio's rebalancing requirements and thus determine how a portfolio performs under various market conditions e.g. median performance, trending, oscillating 1. Buy and hold is a passive strategy that requires no rebalancing and results in a linear payoff 2. Constant mix allocation requires periodic rebalancing to reestablish the strategic asset allocation as asset values change over time. Upward trending risky assets are sold while downward trending risky assets are purchased to maintain the constant mix, which results in a concave payoff. Concave strategies, which are contrarian in nature, will outperform linear (buy and hold) and convex (CPPI, option-based) strategies in an oscillating market that lacks a defined trend. 3. Constant-proportion portfolio insurance and option-based portfolio insurance strategies aim to invest in risky assets based on a cushion (and a multiplier) between the portfolio value and a pre-determined floor value. As portfolio value increases above the floor value (as the cushion increases) more risky assets are held in the portfolio. Risky assets are sold if that cushion falls. Generally, risky assets are purchased as they increase in value and are sold as they decrease in value. This rebalancing profile results in a convex payoff. Convex strategies are momentum-following in nature and will tend to outperform linear (buy and hold) and concave (constant mix) strategies in a trending market with minimum reversals. Changing the parameters underlying dynamic asset allocation strategies allows the manager to adjust the aggressiveness of the strategy (by decreasing the multiplier) or to lock-in profits after a bull-run (by increasing the floor). As the multiplier approaches 1, the CPPI strategy effectively becomes a buy and hold strategy. If the floor increases in lockstep with total portfolio value, CPPI effectively becomes constant mix.

convenience yield

The non-monetary benefit from holding physical commodity ready for use. Inversely related to inventory levels. Factors that affect the convenience yield: 1. Inventory levels - move inversely with convenience yields; higher inventory levels typically result in lower convenience yields and lower spot prices relative to futures price (benefit to holding commodity today is not as great) 2. Volatility - positive relationship with convenience yield; low inventory levels tend to correspond to higher spot prices and higher volatility, resulting in higher convenience yield 3. Commodity futures prices - moves inversely with convenience yield; higher futures prices leads to speculative inventory buildup today, reducing the convenience yield

projected benefit obligation (PBO) and surplus

The present value of all estimated future benefits to be paid to beneficiaries The funded status is the difference between the fair market value of plan assets and the PBO Surplus risk arises from changes in the value of the plan's assets and the present value of its liabilities

risk budgeting

The process of selecting a maximum amount of desired total risk for a portfolio and allocating the portfolio in such a way that the combined risks of the portfolio's individual asset classes do not exceed the selected limit. Risk can be measured in absolute terms (standard deviation, value at risk) or relative terms (standard deviation of tracking error, beta)

tail risk

The risk of a severe decline in portfolio value with returns occurring in the extreme left tail of the return distribution. Methods to mitigate tail risk: 1. Reallocate more funds from alternatives to cash and risk-free debt. 2. Estimating portfolio's equity exposure and hedging using equity derivatives e.g. options 3. Foregoing expensive equity options and instead purchasing put options on currency, commodity, and credit markets and buying (selling) call options on volatility when they are underpriced (overpriced) 4. Allocations to defensive bets within asset classes to reduce crisis losses e.g. high quality in fixed income, managed futures

pension plan asset-liability management SAA

Two strategic buckets: hedging bucket and growth bucket; goal is to minimize need for future contributions into the plan by the sponsor Hedging bucket assets seek to track the plan's liabilities (positive correlation) in order to minimize the volatility of the plan surplus. Will generally hold assets that are negatively correlated with interest rates, positively correlated with inflation, and positively correlated with population longevity e.g. long-term bonds, inflation-sensitive bonds, health care stocks: 1. Duration matching approach - match duration of assets and plan liabilities 2. Cash flow matching approach - matching planned future cash flows with plan cash flow needs 3. Overlay approach - use derivative securities to create required hedges Growth bucket is designed to allocate surplus assets to riskier investments in hopes of enjoying more substantial returns than the hedging bucket; goal is to outperform growth rate in plan liabilities

alternative mutual funds (AMFs)

Unlike ordinary mutual funds can invest in derivatives, can use leverage, and take short positions. Offers daily liquidity so can only be offered for strategies that use liquid instruments. Provide investors with transparency, daily liquidity, no investment minimums, and lower fees (no incentive fee and much lower management fee). Risk reducing restrictions: - leverage limited to 33% of gross value - no position greater than 25% of portfolio value - 90% of income must be generated from permitted sources

unlisted vs. listed real estate funds

Unlisted funds include open-end real estate funds, closed-end real estate funds, and real estate funds of funds; benefits include diversification, access to skilled managers, access to subsectors, and tax advantages; disadvantages include cash drag, substantial fees, leverage, and illiquidity Listed funds include REITS, real estate operating companies, and ETFs; advantages include diversification, liquidity, information/price discovery because of daily trading and arbitrage opportunities, immediate exposure to real estate, access to subsectors, tax advantages; disadvantages include values that can diverge significantly from NAV, and high correlation to equities that reduce diversification benefits

NPI vs. FTSE NAREIT U.S. Real Estate Index Series

Used as proxies for smoothed and unsmoothed data, respectively. Mean returns are similar but, predictably, standard deviation for NPI is substantially lower. NPI is unleveraged. NPI exhibits substantially more autocorrelation than the NAREIT (84% vs. 21%)

volatility

Volatility returns are negatively correlated to market index returns. A long position in a volatility derivative is designed to hedge the short volatility inherent in many investments. Delta-neutral hedge removes exposure to changes in the underlying. Delta-neutral hedge with positive gamma (long option) performs well when volatility is high, performs poorly when volatility is low, and have no directional risk. Profitabilitydepends on the realized vol of the underlying asset. 6 properties of realized vol: 1. Realized vol will change exhibit mean reversion 2. Realized vol often remains low for long periods of time 3. May be high in the short-term but tends to be stable in the long-term 4. Usually rises in equities during down markets and falls in up markets 5. Rate of increase in realized vol in down markets is greater than the rate of decrease in up markets 6. More volatility gives rise to greater risk aversion Studies have shown that there is a consistent positive difference between implied volatility and realized volatility --> positive risk premia in shorting volatility; short volatility drawdowns are quick (< 1 year) because realized vol quickly mean reverts and after a vol spike there is greater demand for long volatility positions (investors willing to pay more for downside protection) Short volatility positions earn two volatility risk premia: volatility diffusion (the risk of vol changes from ongoing buildup of small changes in volatility over time) and volatility jump (risk of sudden, abrupt increases in vol)

PE financial statements

aka the audits are the main financial documents that are reviewed by investors during the ODD process 1. Opinion letter 2. Statement of assets and liabilities 3. Statement of operations 4. Statement of cash flows 5. Statement of changes 6. Schedule of investments

longevity risk transfer instruments

buy-in transaction - pension plan pays an up-front premium to an insurer in exchange for periodic benefit payments; sponsor keeps assets and liabilities buy-out transaction - pension plan sends an up-front premium as well as its assets and liabilities to an insurer; insurer assumes responsibility for paying benefits longevity swap transaction - pension plan pays periodic premiums to a counterparty who in turn pays the plan sponsor periodic payments that are based on the difference between expected and actual benefit payments Risks: 1. Counterparty risk is the main risk arising from longevity risk transfers 2. Basis risk - the hedge is imperfect 3. Contract rollover risk 4. Opactiy risk - if buyer and seller have differing levels of experience

cash in to cash out ratio

cash in / cash out -1 implies no revenues, 0 implies breakeven, positive ratio indicates profit

due diligence

two types: investment process due diligence and operational due diligence investment due diligence: 1. quantitative screening 2. investment team and organizational attributes 3. investment process review 4. performance analysis operational due diligence - important to protect investors from losses due to operational errors/oversights and fraud 1. Document and legal review 2. Verification of vendor relationships 3. Background checks 4. On-site visits

alternative asset performance evaluation

unlike in traditional assets, alpha is difficult to define in alternatives investing; success can be defined as positive absolute return over a market cycle, return greater than an available liquid substitute, or risk-adjusted return greater than published peer group returns