Alternative Investments
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Black Keith H.. Alternative Investments
Preface
Acknowledgments
About the Authors
Part 1. Asset Allocation and Institutional Investors
CHAPTER 1. Asset Allocation Processes and the Mean-Variance Model
1.1 Importance of Asset Allocation
1.2 The Five Steps of the Asset Allocation Process
1.3 Asset Owners
1.3.1 Endowments and Foundations
1.3.2 Pension Funds
1.3.3 Sovereign Wealth Funds
1.3.4 Family Offices
1.4 Objectives and Constraints
1.5 Investment Policy Objectives
1.5.1 Evaluating Objectives with Expected Return and Standard Deviations
1.5.2 Evaluating Risk and Return with Utility
1.5.3 Risk Aversion and the Shape of the Utility Function
1.5.4 Expressing Utility Functions in Terms of Expected Return and Variance
1.5.5 Expressing Utility Functions with Higher Moments
1.5.6 Expressing Utility Functions with Value at Risk
1.5.7 Using Risk Aversion to Manage a Defined Benefit Pension Fund
1.5.8 Finding Investor Risk Aversion from the Asset Allocation Decision
1.5.9 Managing Assets with Risk Aversion and Growing Liabilities
1.6 Investment Policy Constraints
1.6.1 Investment Policy Internal Constraints
1.6.2 Investment Policy and the Two Major Types of External Constraints
1.7 Preparing an Investment Policy Statement
1.7.1 Seven Common Components of an Investment Policy Statement
1.7.2 Strategic Asset Allocation: Risk and Return
1.7.3 Developing a Strategic Asset Allocation
1.7.4 A Tactical Asset Allocation Strategy
1.8 Implementation
1.8.1 Mean-Variance Optimization
1.8.2 Mean-Variance Optimization with a Risky and Riskless Asset
1.8.3 Mean-Variance Optimization with Growing Liabilities
1.8.4 Mean-Variance Optimization with Multiple Risky Assets
1.8.5 Hurdle Rate for Mean-Variance Optimization
1.8.6 Issues in Using Optimization
1.8.7 Optimizers as Error Maximizers
1.8.8 Data Issues for Illiquid Assets
1.8.9 Data Issues for Large-Scale Optimization
1.8.10 Mean-Variance Ignores Higher Moments
1.8.11 Other Issues in Mean-Variance Optimization
1.9 Conclusion
References
CHAPTER 2. Tactical Asset Allocation, Mean-Variance Extensions, Risk Budgeting, Risk Parity, and Factor Investing
2.1 Tactical Asset Allocation
2.1.1 TAA and the Fundamental Law of Active Management
2.1.2 FLOAM and the Cost of Active Management of Alternatives
2.1.3 Costs of Actively Managing Portfolios with Alternatives
2.1.3.1 The Cost of Forgone Loss Carryforward
2.1.3.2 Four Other Costs of Replacing Managers
2.1.4 Three Observations on TAA and Portfolio Reallocation Costs
2.1.5 Keys to a Successful TAA Process
2.1.5.1 The TAA Process and Return Prediction
2.1.5.2 Three Notable Characteristics of Sound TAA Model Development
2.1.5.3 Fundamental Analysis Underlying TAA Models
2.1.5.4 Technical Analysis Underlying TAA Models
2.2 Extensions to the Mean-Variance Approach
2.2.1 Adjustment of the Mean-Variance Approach for Illiquidity
2.2.2 Adjustment of the Mean-Variance Approach for Factor Exposure
2.2.3 Adjustment of the Mean-Variance Approach for Estimation Risk
2.3 Risk Budgeting
2.3.1 Specifications in Risk Budgeting
2.3.2 Implementing a Risk Budgeting Approach
2.3.3 A Three-Asset Example of Risk Budgeting
2.3.4 Applying Risk Budgeting Using Factors
2.4 Risk Parity
2.4.1 Three Steps in Implementing the Risk Parity Approach
2.4.2 Creating a Portfolio Using the Risk Parity Approach
2.4.3 The Primary Economic Rationale for the Risk Parity Approach
2.4.4 Four Rationales for Risk Parity That Can Be Rejected
2.4.5 Equally Weighted and Volatility-Weighted Portfolios
2.5 Factor Investing
2.5.1 The Emergence of Risk Factor Analysis and Three Important Observations
2.5.2 How Risk Factors Are Described
2.5.3 Risk Premiums Vary across Risk Factors
2.5.4 Risk Factor Returns Vary across Market Conditions
2.5.5 Risk Factors and Investability
2.5.6 Risk Allocation Based on Risk Factors
2.5.7 Performance with Allocations Based on Risk Factors
2.6 Conclusion
References
CHAPTER 3. The Endowment Model
3.1 Defining Endowments and Foundations
3.2 Intergenerational Equity, Inflation, and Spending Challenges
3.3 The Endowment Model
3.4 Why Might Large Endowments Outperform?
3.4.1 An Aggressive Asset Allocation
3.4.2 Effective Investment Manager Research
3.4.3 First-Mover Advantage
3.4.4 Access to a Network of Talented Alumni
3.4.5 Acceptance of Liquidity Risk
3.4.6 Sophisticated Investment Staff and Board Oversight
3.5 Risks of the Endowment Model
3.5.1 Spending Rates and Inflation
3.5.2 Liquidity Issues
3.5.3 Rebalancing and Tactical Asset Allocation
3.5.4 Tail Risk
3.6 Conclusion
References
CHAPTER 4. Pension Fund Portfolio Management
4.1 Development, Motivations, and Types of Pension Plans
4.1.1 Development of Pension Plans
4.1.2 Motivations to Using Pension Plans
4.1.3 Three Basic Types of Pension Plans
4.2 Risk Tolerance and Asset Allocation
4.2.1 Three Approaches to Managing the Assets of Defined Benefit Plan
4.2.1.1 Asset-Focused Risk Management
4.2.1.2 Asset-Liability Risk Management Perspective
4.2.1.3 Integrated Asset-Liability Risk Management
4.2.2 Four Factors Driving the Impact of Liabilities on a Plan's Risk
4.2.3 Five Major Factors Affecting the Risk Tolerance of the Plan Sponsor
4.2.4 Strategic Asset Allocation of a Pension Plan Using Two Buckets
4.3 Defined Benefit Plans
4.3.1 Pension Plan Portability and Job Mobility
4.3.2 Defining Liabilities: Accumulated Benefit Obligation and Projected Benefit Obligation
4.3.3 Funded Status and Surplus Risk
4.3.4 Why Defined Benefit Plans Are Withering
4.3.5 Asset Allocation and Liability-Driven Investing
4.4 Governmental Social Security Plans
4.5 Contrasting Defined Benefit and Contribution Plans
4.5.1 Defined Contribution Plans
4.5.2 Plan Differences in Portability, Longevity Risk, and Investment Options
4.5.3 Asset Allocation in Defined Contribution Plans
4.5.4 Target-Date Funds and Alternative Investments within Pension Plans
4.6 Annuities for Retirement Income
4.6.1 Financial Phases Relative to Retirement
4.6.2 Three Important Risks to Retirees
4.6.3 Estimating Exposure to Longevity Risk
4.6.4 Two Major Types of Annuities
4.6.5 Analysis of the Value of a Growth Annuity
4.7 Conclusion
References
CHAPTER 5. Sovereign Wealth Funds
5.1 Sources of Sovereign Wealth
5.1.1 Accounting for Changes in the Reserve Account
5.1.2 Changes in the Reserve Account and Five Drivers of Currency Exchange Rates
5.1.3 Commodity Exports and the Reserve Account
5.2 Four Types of Sovereign Wealth Funds
5.2.1 Stabilization Funds
5.2.2 Reserve and Savings Funds
5.2.3 Development Funds
5.3 Establishment and Management of Sovereign Wealth Funds
5.3.1 Four Common Motivations to Establishing a Sovereign Wealth Fund
5.3.2 Investment Management of Sovereign Wealth Funds
5.3.3 Dutch Disease and Sterilization Policies
5.3.4 Managing the Size of a Sovereign Wealth Fund
5.4 Emergence of Sovereign Wealth Funds
5.5 Governance and Political Risks of SWFs
5.5.1 Governance of SWFs
5.5.2 Ten Principles of the Linaburg-Maduell Transparency Index
5.5.3 Santiago Principles
5.6 Analysis of Three Sovereign Wealth Funds
5.6.1 Government Pension Fund Global (Norway)
5.6.2 China Investment Corporation
5.6.3 Temasek Holdings (Singapore)
5.7 Conclusion
References
CHAPTER 6. The Family Office Model
6.1 Identifying Family Offices
6.2 Goals, Benefits, and Business Models of Family Offices
6.2.1 General Goals of the Family Office
6.2.2 Benefits of the Family Office
6.2.3 Models and Structure of the Family Office
6.3 Family Office Goals by Generations
6.3.1 First-Generation Wealth
6.3.2 Risk Management of First-Generation Wealth
6.3.3 Benchmarking First-Generation Wealth
6.3.4 Goals of the Second Generation and Beyond
6.4 Macroeconomic Exposures of Family Offices
6.5 Income Taxes of Family Offices
6.5.1 Tax Efficiency and Wealth Management
6.5.2 Taxability of Short-Term and Long-Term Capital Gains
6.5.3 Tax Efficiency and Hedge Fund Investment Strategies
6.6 Lifestyle Assets of Family Offices
6.6.1 Art as a Lifestyle Asset
6.6.2 Lifestyle Wealth Storage and Other Costs
6.6.3 Lifestyle Assets and Portfolio Management
6.6.4 Concierge Services
6.7 Family Office Governance
6.7.1 Governance Structures of Family Offices
6.7.2 The Challenges of Family Wealth Sustainability
6.7.3 Strategies to Maintain Family Wealth
6.7.4 Family Office Inheritance and Succession Strategies
6.8 Charity, Philanthropy, and Impact Investing
6.8.1 Charity and Philanthropy
6.8.2 Impact Investing
6.9 Ten Competitive Advantages of Family Offices
6.1 °Conclusion
References
PART 2. Private Equity
CHAPTER 7. Private Equity Market Structure
7.1 Main Strategies of Private Equity Investment
7.2 Main Differences between Venture Capital and Buyout
7.2.1 Business Models of Venture Capital and Buyout
7.2.2 Deal Structuring of Venture Capital and Buyout
7.2.3 Role of the PE Manager in Venture Capital and Buyout
7.3 PE Funds as Intermediaries
7.3.1 PE Fund Intermediation and Risk
7.3.2 PE Fund Intermediation and Efficient Incentives
7.3.3 Forms of PE Fund Intermediation
7.3.4 The Markets for PE Funds
7.4 PE Funds of Funds as Intermediaries
7.4.1 PE Funds-of-Funds Costs
7.4.2 Added Value of PE Funds of Funds
7.4.2.1 Diversification and Intermediation
7.4.2.2 Resources and Information
7.4.2.3 Selection Skills and Expertise
7.4.2.4 Incentives and Oversight
7.5 The Relationship Life Cycle between LPs and GPs
7.6 Limited Partnership Key Features
7.6.1 Fit with Existing Market Environment
7.6.2 Corporate Governance in PE Funds
7.6.3 Investment Objectives, Fund Size, and Fund Term
7.6.4 Management Fees and Expenses
7.6.5 Carried Interest
7.6.6 Preferred Return
7.6.7 GP's Contribution
7.6.8 Key-Person Provision
7.6.9 Termination and Divorce
7.6.10 Distribution Waterfall
7.7 Co-Investments
7.7.1 Direct Investments versus Co-Investments
7.7.2 Expected Advantages of Co-Investing
7.7.3 Expected Disadvantages of Co-Investing
7.7.4 Investment Process for Co-Investing
7.8 Conclusion
References
CHAPTER 8. Private Equity Benchmarking
8.1 The Valuation of PE Assets
8.2 Measuring Performance of PE Funds
8.2.1 Return Measures for PE Funds
8.2.2 Internal Rate of Return
8.2.3 Modified Internal Rate of Return
8.2.4 Other Commonly Used Performance Measures
8.2.5 The J-Curve
8.3 Benchmark Types
8.4 Asset-Based Benchmarks
8.4.1 Listed Private Equity
8.4.2 Public Equity Indices
8.4.2.1 Applying Public Equity Indices
8.5 Peer Groups
8.5.1 Structure of PE Peer-Group Data
8.5.2 PE Peer-Group-Data Providers
8.5.3 PE Peer-Group Characteristics
8.5.4 Biases
8.5.5 Controlling for Risk Differences
8.6 What Is an Appropriate Benchmark?
8.6.1 Benchmark Properties
8.6.2 Benchmark Selection
8.7 Example for Benchmarking PE Funds
8.7.1 Apply IIRR to Examples of PE Fund Returns
8.7.2 Apply the TVPI, the DPI, and the RVPI to Examples of PE Funds
8.7.3 Apply a Classic Benchmark Analysis to Examples of PE Funds
8.7.4 Apply a Public Market Equivalent Analysis to Examples of PE Funds
8.8 Portfolio of PE Funds
8.8.1 Performance Measures
8.8.2 Determining Portfolio Benchmarks
8.8.3 Monte Carlo Simulation
8.9 Conclusion
References
CHAPTER 9. Fund Manager Selection and Monitoring
9.1 Performance Persistence
9.1.1 The Seductive Case for Performance Persistence
9.1.2 Six Challenges to the Performance Persistence Hypothesis
9.1.3 Performance Persistence Hypothesis and Transition Matrices
9.1.4 Performance Persistence Implementation Issues
9.2 Manager Selection and Deal Sourcing
9.2.1 Determination of the Wish List of Fund Characteristics
9.2.2 Classifying Management Teams
9.2.3 Deal Sourcing
9.3 Decision-Making and Commitment
9.4 Principles of Fund Monitoring
9.4.1 Monitoring as Part of a Control System
9.4.2 Monitoring Trade-Offs
9.5 Monitoring Objectives
9.5.1 Portfolio Management
9.5.2 Monitoring the Risk of Style Drift
9.5.3 Creating Value through Monitoring
9.6 Information Gathering and Monitoring
9.6.1 Transparency
9.6.2 Standard Monitoring Information
9.6.3 Specific Information
9.7 Actions Resulting from Monitoring
9.7.1 Three Forms of Active Involvement in the Fund's Governance Process
9.7.2 Two Actions outside the Fund's Governance Process
9.7.3 Two Actions outside Fund Investing
9.8 The Secondary Market
9.8.1 Market Development
9.8.2 Market Size
9.8.3 Buyer Motivations
9.8.4 Seller Motivations
9.8.5 Secondary Market Investment Process
9.8.6 Sourcing Secondary Opportunities
9.8.7 Pricing Secondary Stakes
9.8.8 Limitations of the Secondary Market
9.9 Conclusion
References
CHAPTER 10. Private Equity Operational Due Diligence
10.1 The Scope and Importance of Operational Due Diligence
10.1.1 Operational Due Diligence Is Driven by Operational Risk
10.1.2 Distinguishing Operational Due Diligence from Investment Due Diligence
10.1.3 Why Operational Due Diligence Is So Important in Private Equity
10.1.4 Five Key Benefits of Operational Due Diligence for Private Equity Funds
10.1.5 Four Explanations for the Expanding Scope of Operational Due Diligence
10.2 Eight Core Elements of the Operational Due Diligence Process
10.3 Private Equity Operational Due Diligence Document Collection Process
10.4 Analyzing Private Equity Legal Documentation during Operational Due Diligence
10.4.1 Two Primary Motivations for Designing Private Equity Legal Structures
10.4.2 Common Private Equity Legal Structures
10.4.3 Understanding Offering Memoranda Functions
10.4.4 Distinguishing between Legal Counsel and LP ODD Legal Document Reviews
10.4.5 Analyzing Other Common Private Equity Offering Memorandum Terms
10.5 Operational Due Diligence beyond Legal Document Analysis
10.5.1 Analyzing Private Equity Valuations in the Context of Legal Documentation
10.5.2 Analyzing Private Equity Advisory Committees
10.5.3 Private Equity Audited Financial Statement Review
10.5.4 Information Technology and Business Continuity Planning/Disaster Recovery Documentation Review
10.6 On-Site Manager Visits
10.6.1 Selection of Visit Location
10.6.2 Desk Reviews Are Not Best Practice
10.6.3 On-Site Visit Agenda Development
10.7 Evaluating Meta Risk
10.8 Fund Service Provider Review and Confirmation
10.9 Ongoing Private Equity Monitoring Considerations
10.1 °Conclusion
References and Further Readings
CHAPTER 11. Private Equity Investment Process and Portfolio Management
11.1 Investment Process
11.1.1 Portfolio Objectives
11.1.2 How Much to Allocate to Private Equity?
11.2 Private Equity Portfolio: Design
11.2.1 Fund Selection
11.2.2 Monitoring
11.2.3 Liquidity Management
11.2.4 Actions and Implementation
11.3 Private Equity Portfolio: Construction
11.3.1 Main Approaches
11.3.2 Bottom-Up Approach
11.3.3 Top-Down Approach
11.3.4 Mixed Approach
11.4 Risk-Return Management
11.4.1 Core-Satellite Approach
11.4.2 Diversification
11.4.3 Naïve Diversification
11.4.4 Cost-Averaging and Market-Timing Approaches
11.5 Conclusion
References
CHAPTER 12. Measuring Private Equity Risk
12.1 Four Significant Risks of Private Equity
12.2 Modeling Private Equity
12.2.1 Buy-to-Sell versus Buy-to-Keep
12.2.2 Private Equity as Arbitrage
12.2.3 How Risky Is Private Equity?
12.3 What Is the Value of a Private Equity Asset?
12.3.1 Investments in Funds
12.3.2 Impact of Undrawn Commitments
12.4 Applying the VaR Concept to Private Equity
12.4.1 Problems and Limitations
12.4.2 A VaR for Portfolios of Private Equity Funds?
12.5 Calculating VaR Based on Cash Flow at Risk
12.5.1 Value at Risk Based on Cash Flow Volatility
12.5.2 Fund Growth Calculation
12.6 Conclusion
References
CHAPTER 13. The Management of Liquidity
13.1 Identifying Illiquidity and Managing Cash Flows
13.1.1 Four Advantages of Modeling Private Equity Cash Flows
13.1.2 Defining Illiquid Assets
13.1.3 Funding Risk as a Source of Illiquidity Risk
13.1.4 Exit Risk as a Source of Illiquidity Risk
13.2 Private Equity Cash Flow Schedules
13.2.1 Investment Period
13.2.2 Harvesting Period
13.3 Five Sources of Liquidity
13.4 Investment Strategies for Undrawn Capital
13.5 Modeling Cash Flow Projections
13.5.1 Long-Term Management of Investment Commitments
13.5.2 Four Inputs to Projection Models
13.6 Three Approaches to Forming Model Projections
13.6.1 Basing Model Projections on Estimates
13.6.1.1 An Example of Estimation Techniques
13.6.1.2 Monte Carlo Simulation and Estimates
13.6.1.3 Implementation Issues Using Estimates
13.6.2 Basing Model Projections on Forecasts
13.6.3 Basing Model Projections on Scenarios
13.7 Overcommitment
13.8 Conclusion
References
PART 3. Real Assets
CHAPTER 14. Real Estate as an Investment
14.1 Attributes of Real Estate
14.1.1 Five Potential Advantages of Real Estate
14.1.2 Three Potential Disadvantages of Real Estate
14.2 Asset Allocation
14.2.1 Heterogeneity within Subcategories
14.2.2 Top-Down Asset Allocation
14.2.3 Bottom-Up Asset Allocation
14.3 Categories of Real Estate
14.3.1 Equity versus Debt
14.3.2 Domestic versus International
14.3.3 Residential versus Commercial
14.3.4 Private versus Public
14.3.5 Real Estate Categorization by Market
14.3.6 Risk and Return Classifications
14.3.7 The Focus on Private Commercial Real Estate
14.4 Return Drivers of Real Estate
14.5 The Four-Quadrant Model
14.5.1 An Illustration of the Four-Quadrant Model: Explaining Real Estate Market Booms and Busts
14.6 Conclusion
References
CHAPTER 15. Real Estate Indices and Unsmoothing Techniques
15.1 Smoothed Pricing
15.1.1 Price Smoothing and Arbitrage in a Perfect Market
15.1.2 Persistence in Price Smoothing
15.1.3 Problems Resulting from Price Smoothing
15.2 Models of Price and Return Smoothing
15.2.1 Reported Prices as Lags of True Prices
15.2.2 Modeling Lagged Returns Rather Than Prices
15.2.3 Estimating the Parameter for First-Order Autocorrelation
15.2.4 Four Reasons for Smoothed Prices and Delayed Price Changes in an Index
15.3 Unsmoothing a Price or Return Series
15.3.1 Unsmoothing First-Order Autocorrelation Given ρ
15.3.2 The Three Steps of Unsmoothing
15.3.3 Unsmoothing Using Prices Rather Than Returns
15.3.4 Unsmoothing Returns with Higher-Order Autocorrelation
15.4 An Illustration of Unsmoothing
15.4.1 The Smoothed Data and the Market Data
15.4.2 Estimating the First-Order Autocorrelation Coefficient
15.4.3 Unsmoothing the Smoothed Return Series Given Rho (ρ)
15.4.4 The Relationship between the Variances of True and Reported Returns
15.4.5 The Relationship between the Betas of True and Reported Returns
15.4.6 Interpreting the Results of Unsmoothing
15.5 Noisy Pricing
15.6 Appraisal-Based Real Estate Indices
15.6.1 Approaches to Appraisals
15.6.1.1 Three Approaches to Forming Appraisals
15.6.1.2 Two Advantages of Appraisal-Based Models
15.6.1.3 Three Disadvantages of Appraisal-Based Models
15.6.2 The NCREIF Property Index, an Example of an Appraisal-Based Index
15.6.3 Two Popular Methods of Appraisals
15.6.4 Illustration of the Income Approach
15.7 Transaction-Based Indices (Repeat-Sales and Hedonic)
15.7.1 The Repeat-Sales Method
15.7.1.1 Two Advantages of the Repeat-Sales Method
15.7.1.2 Three Disadvantages of the Repeat-Sales Method
15.7.2 The Hedonic Pricing Method
15.7.2.1 Three Steps to Calculating a Hedonic Price Index
15.7.2.2 Five Advantages of the Hedonic Pricing Model
15.7.2.3 Six Disadvantages of the Hedonic Pricing Model
15.7.3 Contrasting Repeat-Sales and Hedonic Price Indices
15.7.4 Sample Biases in Transaction-Based Indices
15.8 Description of Major Real Estate Indices
15.8.1 Housing or Residential Real Estate Properties Indices
15.8.2 Farmland and Timberland Indices
15.8.3 Market-Traded Real Estate Vehicles
15.8.4 Real Estate Debt or Mortgage Indices
15.9 Real Estate Indices Performance
15.9.1 Real Estate Indices Performance
15.9.2 Mortgage REITs Performance
15.9.3 Equity REIT Performance
15.1 °Conclusion
References
CHAPTER 16. Investment Styles, Portfolio Allocation, and Real Estate Derivatives
16.1 Defining the Three NCREIF Real Estate Styles
16.2 Differentiating Styles with Eight Attributes
16.3 Three Purposes of Real Estate Style Analysis
16.4 Real Estate Style Boxes
16.5 Cap Rates and Expected Returns
16.6 Developing Risk and Return Expectations with Styles
16.6.1 Core Real Estate Expected Return
16.6.2 Core Real Estate Risk
16.6.3 Return Estimates for Noncore Assets and the Risk-Premium Approach
16.6.4 Examples of Return Estimates for Noncore Style Assets
16.7 Characteristics of Real Estate Derivatives
16.7.1 Three Benefits of Housing Price Derivatives
16.7.2 Two Critical Factors for Effective Risk Management with Derivatives
16.7.3 Baum and Hartzell's Seven Advantages of Property Derivatives
16.7.4 Baum and Hartzell's Six Disadvantages of Property Derivatives
16.8 Types of Real Estate Derivatives and Indices
16.8.1 Property Total Return Swaps
16.8.2 Forwards, Futures, and Options Contracts
16.8.3 Real Estate Index Notes
16.8.4 Traded Derivatives of Mortgage-Backed Securities
16.8.5 Stock Market–Based Property Return Indices
16.9 Conclusion
References
CHAPTER 17. Listed versus Unlisted Real Estate Investments
17.1 Unlisted Real Estate Funds
17.1.1 Open-End Funds
17.1.2 Closed-End Funds
17.1.3 Funds of Funds
17.1.4 Four Advantages of Unlisted Real Estate Funds
17.1.5 Three Disadvantages of Unlisted Real Estate Funds
17.2 Listed Real Estate Funds
17.2.1 REITs and REOCs
17.2.2 Exchange-Traded Funds Based on Real Estate Indices
17.2.3 Six Advantages of Listed Real Estate Funds
17.2.4 Two Disadvantages of Listed Real Estate Funds
17.2.5 Global REITs
17.2.6 Non-Traded REITs
17.3 Market-Based versus Appraisal-Based Returns
17.3.1 Histograms of U.S. Real Estate Returns
17.3.2 Four Explanations of the Relationship of Appraisal-Based and Market-Based Volatilities
17.3.3 The Importance of Accurate Pricing and Risk Estimation
17.4 Arbitrage, Liquidity, and Segmentation
17.4.1 Pooling of Securities versus Securitization
17.4.2 Exchange-Traded Funds and Arbitrage
17.4.3 The Hedging of Unlisted Real Estate Values with Listed Real Estate Values
17.4.4 Two Views of REITs as Indicators of Private Real Estate Values
17.4.5 Financial Market Segmentation
17.4.6 Real Estate Turnover, Dealer Sales, and Agency Costs
17.4.7 Real Estate Price Volatility and Liquidity
17.4.8 Evidence from Correlations over 20 Years
17.4.9 Real Estate as a Diversifier
17.5 Conclusion
References
CHAPTER 18. International Real Estate Investments
18.1 Overview of International Real Estate Investing
18.2 Opportunities in International Real Estate Investing
18.2.1 Expectation of Higher Returns
18.2.2 Diversification Benefits
18.2.3 Importance of Income Taxation Analysis
18.2.4 Depreciation Tax Shields
18.2.5 Deferral of Taxation of Gains
18.2.6 Depreciation, Deferral, and Leverage Combined
18.2.7 Leverage
18.3 Challenges to International Real Estate Investing
18.3.1 Three Reasons Why Agency Relationships Are Important
18.3.2 Information Asymmetries
18.3.3 Liquidity and Transaction Costs
18.3.4 Political and Economic Risks
18.3.5 Exchange Rate Risk
18.3.6 Legal Risks
18.4 Establishing a Global Real Estate Equity Investment Program
18.4.1 International Real Estate Investment Trusts (REITs)
18.4.2 Summary of Forms of Real Estate Investment
18.5 Conclusion
References
CHAPTER 19. Infrastructure as an Investment
19.1 Infrastructure Assets
19.1.1 Distinguishing Infrastructure
19.1.2 Three Approaches to Classifying the Economic Nature of Infrastructure
19.1.3 The Demand for Infrastructure Assets
19.1.4 The Supply of Infrastructure Assets
19.2 Stage, Location, and Sector of Infrastructure
19.2.1 Stage of Maturity
19.2.2 Geographical Location
19.2.3 Sector Scope
19.3 Twelve Attributes of Infrastructure as Defensive Investments
19.3.1 Inelastic Demand
19.3.2 Monopolistic Market Positions
19.3.3 Regulated Entities
19.3.4 Capital-Intensive Setup, Low Operating Costs
19.3.5 Low Volatility of Operating Cash Flows
19.3.6 Resilience to Economic Downturns
19.3.7 Technology Risk
19.3.8 Long-Term Horizons
19.3.9 Inflation-Indexed Cash Flows
19.3.10 Stable Yield
19.3.11 Low Correlation with Other Asset Classes
19.3.12 Attractive Risk-Adjusted Returns
19.4 Accessing Infrastructure Investment Opportunities
19.4.1 Equity: Private Funds
19.4.2 Equity: Publicly Traded Funds
19.4.3 Equity: Direct Deals
19.4.4 Publicly Traded Infrastructure Companies
19.4.5 Debt
19.5 Classifying Infrastructure Fund Strategies
19.5.1 Active Management
19.5.2 Passive Management
19.5.3 Asset Maturity
19.5.4 Geographic Scope
19.5.5 Sector Scope
19.5.6 Core Infrastructure and Peripheral Infrastructure
19.6 Comparison of Infrastructure with Other Assets
19.6.1 Bonds versus Infrastructure
19.6.2 Real Estate versus Infrastructure
19.6.3 Buyouts versus Infrastructure
19.6.4 Equities versus Infrastructure
19.7 Public-Private Partnerships
19.8 Infrastructure Regulation and Public Policy
19.9 Infrastructure Historical Performance
19.1 °Conclusion
References
CHAPTER 20. Farmland and Timber Investments
20.1 Motivations for and Characteristics of Farmland Investment
20.1.1 Three Motivations of Farmland Investment
20.1.2 Three Characteristics of U.S. Farmland Investment
20.1.3 Overview of Non-U.S. Farmland Investment
20.2 Global Demand for Agricultural Products
20.2.1 Factors Driving Agricultural Demand and Supply
20.2.2 Population Growth, Income Growth, and Changing Food Demands
20.2.3 Biofuels and Demand for Agricultural Products
20.3 Accessing Agricultural Returns
20.3.1 Three Primary Approaches to Accessing Agricultural Asset Returns
20.3.2 Capturing Improvements in Agricultural Yield
20.3.3 Factors Driving Growth in Agricultural Yields
20.3.4 Determinants of Agricultural Profitability
20.3.5 Government Subsidies and Agricultural Returns
20.4 Understanding the Returns to Farmland
20.4.1 Historical Returns to U.S. Farmland
20.4.2 Macroeconomic Factors Explaining U.S. Farmland Returns
20.4.3 Heterogeneity of U.S. Farmland Returns
20.4.4 Farmland Price Appreciation and Farmland Returns
20.5 Investing in Agricultural Infrastructure
20.5.1 Four Economic Functions of Agricultural Infrastructure
20.5.2 Three Drivers of Productivity of Agricultural Infrastructure
20.6 Global Investing in Timberland137
20.6.1 Four Key Attractions to Timber Investment
20.6.2 Returns to Timberland Investing
20.6.3 Risks to International Timber Investing
20.6.4 Rotation
20.7 Farmland and Timber Investments Compared to Other Real Assets
20.7.1 Characteristics of Real Assets
20.7.2 Risk and Return Expectations for Agriculture
20.7.3 Ease of Investment and Liquidity in Agriculture
20.7.4 Inflation Hedge, Portfolio Diversification, and Interest Rate Sensitivity of Agriculture Investment
20.8 Key Points
20.9 Conclusion
References
CHAPTER 21. Investing in Intellectual Property
21.1 Characteristics of Intellectual Property
21.2 Film Production and Distribution
21.2.1 Film Production and Distribution Revenues
21.2.2 Film Production and Distribution Life Cycle
21.2.3 Costs and Financing of Film Production and Distribution
21.2.4 Four Findings from Evidence on Film Production Profitability
21.2.5 Estimating the Relationship of Returns to Film Production
21.3 Visual Works of Art
21.3.1 Reasons for Considering Art as an Investment
21.3.2 Evidence on the Investment Returns to Art
21.3.3 Characteristics Hypothesized to Drive Returns to Art
21.4 R&D and Patents
21.4.1 Estimating Returns to R&D
21.4.2 Accessing R&D through Patents
21.4.3 Patent Acquisition and Licensing Strategies
21.4.4 Patent Enforcement and Litigation Strategies
21.4.5 Patent Sale License-Back Strategies
21.4.6 Patent Lending Strategies
21.4.7 Patent Sales and Pooling
21.4.8 Risks to Investment in Patents
21.5 Intellectual Property and Six Characteristics of Real Assets
21.6 Conclusion
References
Part 4. Commodities
CHAPTER 22. Key Concepts in Commodity Markets
22.1 Economics of Commodity Spot Markets
22.1.1 Commodity Prices and the Business Cycle
22.1.1.1 Commodities and Interest Rates
22.1.1.2 Commodities and Central Bank Policies
22.1.1.3 Commodities, Inflation, and Commodity Price Patterns
22.1.2 The Properties of Spot Commodity Prices
22.1.2.1 Commodity Investing and Long-Run Returns
22.1.2.2 Commodity Prices and Supercycles
22.1.2.3 Commodity Supercycles versus Short-Term Fluctuations
22.2 Commodity Trading Firms, Risks, and Speculation
22.2.1 Commodity Transformation
22.2.2 Seven Commodity Trading Risks
22.2.3 Speculation in Commodity Markets
22.2.4 The Impact of Commodity Speculation on Risk
22.3 Economics of Commodity Futures Markets
22.3.1 Theory of Storage and Convenience Yield
22.3.2 Three Determinants of Convenience Yield
22.3.3 Cost of Carry
22.3.4 Arbitrage and the Cost of Carry without Convenience Yield
22.3.5 Arbitrage and the Cost of Carry with Convenience Yield
22.4 Theories of Commodity Forward Curves
22.4.1 The Slope of the Forward Curve and the Cost of Carry
22.4.2 Market Expectations and Forward Curves
22.4.3 Normal Backwardation and the Liquidity Preference Hypothesis
22.4.4 Storage and Futures Curves
22.4.5 Other Models and Special Cases of Forward Curves
22.5 Decomposition of Returns to Futures-Based Commodity Investment
22.6 Commodities as an Inflation Hedge
22.6.1 Rationale of Commodities as an Inflation Hedge
22.6.2 Evidence Regarding Commodities as an Inflation Hedge
22.6.3 Rationale of Financial Asset Correlations with Inflation and Commodities
22.7 Commodities and Exchange Rates
22.8 Rebalancing and Historical Performance of Commodity Futures
22.8.1 Empirical Evidence on the Effect of Rebalancing on Return
22.8.2 The Effects of Rebalancing When Prices Do Not Mean-Revert
22.8.3 The Effect of Rebalancing on Geometric and Arithmetic Mean Returns
22.8.4 Historical Analysis of Commodity Returns
22.8.5 Historical Commodity Returns and Financialization
22.9 Conclusion
References
CHAPTER 23. Allocation to Commodities
23.1 Five Beneficial Characteristics of Allocations to Commodity Futures
23.1.1 Low Correlation with Stocks and Bonds
23.1.1.1 The Effect of Full Collateralization on Perceived Commodity Risk
23.1.1.2 Liabilities, Futures, and Diversification with Commodities
23.1.1.3 The Evidence on Commodities as a Diversifier
23.1.2 Inflation, Business Cycle, and Event Risk Hedging
23.1.2.1 Commodities, Inflation Hedging, and Investment Horizon
23.1.2.2 Commodities as Diversifiers to Economic Cycles
23.1.2.3 Commodity Performance in the Four Major Business Cycle Phases
23.1.3 Mean Reversion and Diversification Return
23.1.3.1 Benefits of Mean Reversion in Commodity Investing
23.1.3.2 Benefiting from Mean Reversion through Portfolio Rebalancing
23.1.3.3 Volatility Reduction Enhances Geometric Mean Returns, Not Expected Values
23.1.4 Positive Risk Premium
23.1.5 Positive Skewness
23.2 Commodity Investment Strategies
23.3 Directional Strategies
23.4 Relative Value Strategies
23.5 Commodity Futures and Options Spreads
23.5.1 Calendar Spreads
23.5.1.1 Common Calendar Spreads
23.5.1.2 Bull Spreads and Bear Spreads
23.5.1.3 Estimating the Profitability of Spread Trading
23.5.2 Processing Spreads
23.5.3 Substitution Commodity Spreads
23.5.3.1 Two Major Types of Substitutions in Commodities
23.5.3.2 Determining Entry and Exit Points with a Substitution Test Statistic
23.5.3.3 Example of a Substitution Spread Trade
23.5.3.4 Quality and Location Spreads
23.5.4 Intramarket Relative Value Strategies
23.6 Capital Structure and Commodity-Based Corporations
23.6.1 Commodity Risk Management Strategies of Commodity Producers
23.6.2 Commodity Price Risk of the Securities of Commodity Firms
23.6.3 Commodity-Based Equity and Debt Investment Strategies
23.7 Conclusion
References
CHAPTER 24. Accessing Commodity Investment Products
24.1 Direct Physical Ownership of Commodities
24.2 Indirect Ownership of Commodities
24.2.1 Commodity Index Swaps
24.2.2 Public Commodity-Based Equities
24.2.3 Bonds Issued by Commodity Firms
24.2.4 Commodity-Based Mutual Funds and Exchange-Traded Products
24.2.5 Public and Private Commodity Partnerships
24.2.6 Commodity-Linked Investments
24.2.7 Commodity-Based Hedge Funds
24.2.8 Commodity Trade Financing and Production Financing
24.3 Leveraged and Option-Based Structures
24.3.1 Leveraged and Short Commodity Index-Based Products
24.3.2 Leveraged Notes
24.3.3 Principal-Guaranteed Notes
24.4 Commodity Index Basics
24.5 Eight Sources of Commodity Index Returns
24.6 Issues in Commodity Index Design
24.6.1 Value Based versus Quantity Based
24.6.2 Total Return versus Excess Return
24.6.3 Roll Method
24.6.4 Weighting Methodology
24.6.5 First-Generation Commodity Indices
24.7 Performance Enhancements of New Commodity Indices
24.7.1 Analysis of Performance of Commodity Index Enhancements
24.7.2 Second-Generation Enhanced Commodity Indices
24.7.3 Third-Generation Enhanced Commodity Indices
24.8 Commodity Index Return Calculation
24.8.1 Four Challenges with Return Attribution to Commodity Indices
24.8.2 Index Calculation Primer
24.8.2.1 Computation of Spot Return
24.8.2.2 Computation of Excess Return
24.8.2.3 Computation of Total Return
24.8.2.4 Computation of Realized Roll Return
24.8.3 Index Calculation Example
24.9 Conclusion
References
Part 5. Hedge Funds and Managed Futures
CHAPTER 25. Managed Futures
25.1 The Structure of the Managed Futures Industry
25.2 Four Core Dimensions of Managed Futuresnvestment Strategies
25.2.1 Data Sources as a Core Managed Futures Dimension
25.2.2 Implementation Style as a Core Managed Futures Dimension
25.2.3 Strategy Focus as a Core Managed Futures Dimension
25.2.3.1 Momentum as a Strategy Focus
25.2.3.2 Global Macro as a Strategy Focus
25.2.3.3 Relative Value as a Strategy Focus
25.2.3.4 Other Strategy Foci
25.2.4 Time Horizon as a Core Managed Futures Dimension
25.3 Foundations of Managed Futures
25.3.1 The Adaptive Markets Hypothesis
25.3.2 Four Practical Implications of the Adaptive Markets Hypothesis
25.3.3 Market Divergence, Dislocation, and Momentum
25.3.4 Measuring Market Divergence
25.3.5 Crisis Alpha
25.4 Benefits of CTAs
25.4.1 Research Regarding the Benefits of CTAs
25.4.2 Sources of Return for CTAs
25.4.3 Eight Core Benefits of CTAs for Investors
25.5 Systematic Futures Portfolio Construction
25.5.1 The Four Core Decisions of a Futures Trading System
25.5.2 Data Processing in Futures Portfolio Construction
25.5.3 Position Sizing in Futures Portfolio Construction
25.5.4 Market Allocation in Futures Portfolio Construction
25.5.5 Trading Execution in Futures Portfolio Construction
25.6 Conclusion
References
CHAPTER 26. Investing in CTAs
26.1 Historical Performance of CTAs
26.1.1 Statistical Properties of CTA Returns
26.1.2 Return Skewness and Trend Following
26.1.3 Risk Factor Exposure for CTAs
26.1.4 Evidence on Market Divergence and CTAs
26.1.5 Exposure of CTAs to Market Volatility
26.1.6 The Gamma Exposure of CTAs
26.2 Diversification Benefits of CTAs
26.2.1 Crisis Alpha and CTA Performance
26.2.2 CTA Diversification Benefits for a 60/40 Investor
26.2.3 CTA Diversification Benefits for a Fund-of-Funds Investor
26.3 CTA Risk Measurement and Risk Management
26.3.1 Leverage versus Implicit Leverage
26.3.2 Margin Accounts and Collateral Management
26.3.3 Capital at Risk for Managed Futures
26.3.4 Value at Risk for Managed Futures
26.3.5 Drawdown and Managed Futures
26.3.6 Simulation Analysis and Managed Futures
26.3.7 The Omega Ratio and Managed Futures
26.4 Three Approaches to the Benchmarking of CTAs
26.4.1 Benchmarking CTAs with Long-Only Futures Contracts
26.4.2 Benchmarking CTAs with Peer Groups
26.4.3 Benchmarking CTAs with Algorithmic Indices
26.4.4 CTA Benchmarking and Investment Strategy
26.4.5 Five Conclusions from Evidence on CTA Benchmarking
26.5 Managed Accounts and Platforms
26.5.1 Factors Affecting the Choice of Investment Product
26.5.2 Four Factors Driving CTA Portfolio Construction
26.5.3 Structure of CTA Products and CTA Funds
26.5.4 Structuring CTA Products with Managed Accounts
26.5.5 Structuring CTA Products with Platforms
26.6 Conclusion
References
CHAPTER 27. Relative Value Strategies
27.1 Limits to Arbitrage of Relative Valuation
27.1.1 Absence of Arbitrage in Derivative Pricing
27.1.2 Examples of Arbitrage Opportunities
27.1.3 Factors Affecting Limits to Arbitrage
27.1.4 Efficiently Inefficient Markets
27.2 Convertible Arbitrage: An Overview
27.2.1 Three Broad Steps to Convertible Arbitrage
27.2.2 Convertible Bond Underpricing
27.2.3 Arbitrage with Convertible Bonds
27.2.4 A Convertible Bond Example
27.2.5 Valuation of Convertible Securities: Component Approach
27.2.6 Valuation of Convertible Securities: Binomial Model
27.2.7 Convertible Bond Behavior at Various Stock Price Levels
27.2.8 Greeks of Convertible Bonds
27.2.9 Convertible Bond Arbitrage Strategies: Implementation
27.2.1 °Convertible Bond Arbitrage Strategies: Managing Four Non-Equity Risks
27.2.11 Five Sources of Convertible Arbitrage Returns
27.2.12 Market Size and Historical Performance
27.3 Pairs Trading and Market Neutrality
27.3.1 Equity Market-Neutral Strategy: General Framework
27.3.2 Pairs Trading: Conceptual Framework with Four Steps
27.3.3 Implementation of Pairs Trading
27.3.4 Sources of Risk and Return in Pairs Trading
27.3.5 Pairs Trading Market Size and Historical Performance
27.4 Conclusion
References
CHAPTER 28. Hedge Funds: Directional Strategies
28.1 Financial Economics of Directional Strategies
28.1.1 Informational Market Efficiency
28.1.2 Behavioral Finance
28.2 Equity Long/Short
28.2.1 Overview of Investment Opportunities
28.2.2 Value, Growth, and Blend Approaches
28.2.3 Bottom-Up Approach versus Top-Down Approach
28.2.4 Fundamental Equity Valuation Models
28.2.5 Sector-Specific and Activist Investment Approaches
28.2.6 Mechanics of the Long/Short Strategy
28.2.6.1 Idea Generation
28.2.6.2 Optimal Idea Expression
28.2.6.3 Sizing the Position
28.2.6.4 Executing the Trade
28.2.7 Understanding and Managing the Risks of Long/Short Investing
28.2.8 Managerial Expertise and Sources of Returns
28.2.8.1 Expertise of Equity Long/Short Fund Managers
28.2.8.2 Sources of Returns from a Fundamental Long/Short Strategy
28.2.8.3 Long/Short Return Attribution
28.2.9 Fundamental Long/Short Equity Manager's Investment Process
28.3 Global Macro
28.3.1 Introduction to Macro Strategies
28.3.2 Discretionary versus Systematic
28.3.3 Global Macro Schools of Thought
28.3.4 Multistrategy Global Macro Funds
28.3.5 Directional Currency Trades
28.3.6 The Case of Emerging Markets
28.3.7 Four Models for Currency Trading
28.3.8 Carry Models for Currency Trading
28.3.9 Trend-Following and Momentum Models for Currency Trading
28.3.10 Value and Volatility Models for Currency Trading
28.3.11 Risk Management and Portfolio Construction
28.4 Historical Performance of Directional Strategies
28.5 Conclusion
References
CHAPTER 29. Hedge Funds: Credit Strategies
29.1 The Economics of Credit Risk
29.1.1 Adverse Selection and Credit Risk
29.1.2 Moral Hazard and Credit Risk
29.1.3 Probability of Default
29.1.4 Expected Credit Loss
29.2 Overview of Credit Risk Modeling
29.3 The Merton Model
29.3.1 Capital Structure in the Merton Model
29.3.2 The Merton Model and the Black-Scholes Option Pricing Model
29.3.3 The Role of the Credit Spread in the Structural Model
29.3.4 Evaluation of the Merton Model
29.3.5 Four Important Properties of the Merton Model
29.4 Other Structural Models – KMV
29.4.1 Overview of the KMV Credit Risk Model
29.4.2 Using the KMV Model to Estimate a Credit Score
29.4.3 Using the KMV Model to Estimate an Expected Default Frequency
29.5 Reduced-Form Models
29.5.1 Default Intensity in Reduced-Form Models
29.5.2 Valuing Risky Debt with Default Intensity
29.5.3 Relating the Credit Spread to Default Intensity and the Recovery Rate
29.5.4 The Two Predominant Reduced-Form Credit Models
29.6 Pros and Cons of Structural and Reduced-Form Models
29.7 Empirical Credit Models
29.7.1 The Purpose of Altman's Z-Score Model
29.7.2 The Five Determinants of Altman's Z-Scores
29.7.3 Solving for the Z-Score in Altman's Credit Scoring Model
29.7.4 Interpreting Z-Scores in Altman's Credit Scoring Model
29.8 Distressed Debt Investment Strategy
29.8.1 Definition of Distressed Debt
29.8.2 Trade Claims
29.8.3 Size of Universe and Characteristics of Distressed Debt
29.8.4 Causes of Financial Distress
29.8.5 Countercyclical Nature of Distressed Opportunities
29.8.6 Types of Investors and Investment Vehicles in Distressed Debt
29.8.7 Return Drivers: Fundamental Valuation and Informational Inefficiency
29.8.8 Return Drivers: Event/Catalyst and Activism
29.9 Bankruptcy Laws across the Globe
29.9.1 Bankruptcy in the United States
29.9.2 Bankruptcy in the United Kingdom
29.9.3 Bankruptcy in the Rest of Europe
29.9.4 Bankruptcy in the Rest of the World
29.10 Implementation of Distressed Debt Strategies
29.10.1 Implementation through the Loan-to-Own Control-Oriented Approach
29.10.2 Implementation through the Classic Approach
29.10.3 Implementation through the Trading-Oriented Approach
29.10.4 Implementation through a DIP Loan Approach
29.11 Valuation Risks in Distressed Debt Investing
29.11.1 Liquidity Risk in Distressed Investing
29.11.2 Mark-to-Market Risk in Distressed Investing
29.11.3 Legal and Jurisdiction Risk in Distressed Investing
29.12 Asset-Based Lending
29.12.1 A Typical Borrower in Asset-Based Lending
29.12.2 Why Borrowers Select Asset-Based Lending
29.12.3 Features of Asset-Based Lending
29.12.4 Use of Asset-Based Lending Proceeds
29.12.5 Asset-Based Loan Structures and Collateral
29.12.6 Asset-Based Lender Protection and Covenants
29.12.7 Asset-Based Lending Risk
29.12.7.1 Valuation Risk
29.12.7.2 Risks Regarding Process and People
29.12.7.3 Risks Regarding Hedging
29.12.7.4 Legal Risks
29.12.7.5 Risks Regarding Timing/Exit
29.13 Conclusion
References
CHAPTER 30. Volatility, Correlation, and Dispersion Products and Strategies
30.1 Volatility, Risk Factors, and Risk Premiums
30.1.1 Volatility as a Return Factor Exposure
30.1.2 The Volatility Factor Exhibits Negative Market Risk and a Negative Risk Premium
30.1.3 Volatility as an Unobservable but Unique Risk Factor
30.1.4 Using Volatility Derivatives to Hedge Market Risk
30.2 Using Options to Manage Portfolio Volatility Exposure and Risk Premiums
30.2.1 Option Writing as a Short Volatility Strategy
30.2.2 Writing Option Straddles and Strangles as a Short Volatility Strategy
30.2.3 Writing Option Butterflies and Condors as a Short Volatility Strategy
30.2.4 Risk Management of Option Portfolios Using the Greeks
30.2.5 The Volatility Exposure of Delta-Neutral Option Portfolios
30.2.5.1 Long Volatility Exposure from Long Gamma
30.2.5.2 Realized Volatility, Implied Volatility, and Profitability
30.2.5.3 Effects of Re-hedging on Portfolio Profitability
30.2.5.4 The Role of Hedging Activities in Long Gamma, Delta-Neutral Portfolios
30.2.6 Six Properties of Realized Volatility
30.2.7 Implied Volatility Structures of Derivatives
30.2.8 Evidence That Short Volatility Earns a Positive Risk Premium
30.2.9 Dynamics of the Volatility Risk Premium
30.2.10 Two Reasons Why Returns to Volatility Strategies Tend to Recover Quickly
30.2.11 Two Reasons Why Volatility Mean Reversion Is Not Arbitragable
30.3 Modeling Volatility Processes
30.3.1 Volatility Processes with Jump Risk
30.3.2 Volatility Processes and Regime Changes
30.4 Volatility Products
30.4.1 Four Common Features of Volatility and Fixed Income Products
30.4.2 Variance Swaps Tied to Realized Volatility
30.4.3 CBOE Volatility Index (VIX) Products
30.4.3.1 Computation of the CBOE Volatility Index (VIX)
30.4.3.2 Futures Contracts on the CBOE Volatility Index (VIX)
30.4.3.3 The VIX Term Structure and Its Slope as a Proxy for Portfolio Insurance
30.4.3.4 The Determination of the S&P 500 VIX Short-Term Futures Index
30.4.3.5 Options, Exchange-Traded Notes, and Other VIX-Related Products
30.4.4 Correlation Swaps
30.4.4.1 Mechanics of a Correlation Swap
30.4.4.2 Modeling the Price of a Correlation Swap
30.4.4.3 Motivations to Correlation Trading
30.4.4.4 Dispersion Trades
30.4.5 The Common Theme in Volatility Trading
30.5 Option-Based Volatility Strategies
30.5.1 Vertical Intra-Asset (Skew) Option Spreads
30.5.1.1 Mechanics of a Vertical Spread
30.5.1.2 Vertical Spreads and Volatility Skews
30.5.1.3 Vertical Spreads with Delta Hedging
30.5.2 Horizontal Intra-Asset (Skew) Spreads
30.5.3 Inter-Asset Option Spreads
30.6 Volatility Hedge Funds and Their Strategies
30.6.1 Four Subcategories of Volatility Hedge Funds
30.6.2 Normalizing Vega Risk
30.6.3 Return Characteristics of Volatility Funds
30.6.4 Relative Value Volatility Funds
30.6.5 Short Volatility Funds
30.6.6 Long Volatility and Tail Risk Funds
30.6.7 Tests of Four Volatility Strategies for Tail Risk Protection
30.7 Conclusion
References
CHAPTER 31. Hedge Fund Replication
31.1 An Overview of Replication Products
31.2 Potential Benefits of Replication Products
31.3 The Case for Hedge Fund Replication
31.3.1 Estimating the Risk and Return of Funds of Funds
31.3.2 Three Theories for Increased Beta and Decreased Alpha in Hedge Fund Returns
31.3.3 The Aggregate Alpha of the Hedge Fund Industry
31.3.4 Replication Products as a Source of Alpha
31.3.5 Replication Products as a Source of Alternative Beta
31.4 Unique Benefits of Replication Products
31.4.1 Two Key Issues Regarding Fund Replication Benefits
31.4.2 Eight Potential Unique Benefits from Hedge Fund Replication
31.4.2.1 Liquidity as a Replication Benefit
31.4.2.2 Transparency as a Replication Benefit
31.4.2.3 Flexibility as a Replication Benefit
31.4.2.4 Lower Fees as a Replication Benefit
31.4.2.5 Hedging as a Replication Benefit
31.4.2.6 Lower Due Diligence and Monitoring Risks as a Replication Benefit
31.4.2.7 Diversification as a Replication Benefit
31.4.2.8 Benchmarking as a Replication Benefit
31.5 Factor-Based Approach to Replication
31.5.1 Four Issues in Constructing a Factor-Based Replication Product
31.5.2 Three Steps to Factor-Based Replication
31.5.3 Two Key Concepts Regarding Factor-Based Replication
31.5.4 Research on Factor-Based Replication
31.6 Payoff-Distribution Approach
31.6.1 Overview of the Payoff-Distribution Approach
31.6.2 Illustration of the Factor-Based and Payoff-Distribution Replication Approaches
31.6.3 The Key Difference between Payoff-Distribution and Factor-Based Replication
31.6.4 Empirical Evidence on Payoff Distribution
31.7 Algorithmic (Bottom-Up) Approach
31.7.1 Overview of the Algorithmic Approach
31.7.2 An Illustration of the Algorithmic Approach: Merger Arbitrage
31.7.3 An Illustration of the Algorithmic Approach: Convertible Arbitrage
31.7.4 An Illustration of the Algorithmic Approach: Momentum Strategies
31.8 Alternative Mutual Funds
31.8.1 Overview of Alternative Mutual Funds
31.8.2 Three Potential Benefits of Offering Alternative Mutual Funds
31.8.3 Benefits of Alternative Mutual Funds to Investors
31.8.4 Risks of Alternative Mutual Funds
31.9 Exchange-Traded Funds
31.1 °Conclusion
References
CHAPTER 32. Funds of Hedge Funds and Multistrategy Funds
32.1 Approaches to Accessing Hedge Funds
32.1.1 The Direct Approach and Its Three Advantages
32.1.2 The Delegated Approach and Its Services
32.1.3 The Indexed Approach
32.2 Characteristics of Funds of Hedge Funds
32.2.1 Background on Funds of Hedge Funds
32.2.2 Diversification Types of Funds of Hedge Funds
32.2.3 Funds of Hedge Funds Performance Reporting and Potential Biases
32.3 Funds of Funds Performance
32.4 Fund of Hedge Funds Portfolio Construction
32.4.1 AUM-Weighted Approach
32.4.2 Equally Weighted Approach
32.4.3 Equally Risk-Weighted Approach
32.4.4 Mean-Variance (Unconstrained and Constrained) Approach
32.4.5 Mean-Variance with Constraints on Higher Moments Approach
32.4.6 Personal Allocation Biases Approach
32.5 Manager Selection
32.6 Benefits Offered by Funds of Hedge Funds
32.7 Disadvantages of Funds of Hedge Funds
32.8 Funds of Hedge Funds versus Multistrategy Funds
32.9 How Funds of Hedge Funds Add Value
32.9.1 Adding Value through Strategic Allocation
32.9.2 Adding Value through Three Key Decisions in Tactical Allocation
32.9.3 Adding Value through Fund Selection
32.9.4 Evidence Regarding Value Added by Fund-of-Funds Managers
32.10 Hedge Funds Indices
32.10.1 Desirable Characteristics of Indices
32.10.2 Noninvestable Hedge Fund Indices and Five Complicating Issues
32.10.3 Investable Hedge Fund Indices
32.11 Conclusion
References
CHAPTER 33. Hedge Fund Operational Due Diligence
33.1 Distinguishing Hedge Fund and Private Equity Operational Due Diligence
33.2 Four Operational Steps in Analyzing Hedge Fund Operational Trading Procedures
33.3 Analyzing Hedge Fund Cash Management and Movement
33.3.1 Four Primary Purposes of Hedge Fund Cash
33.4 Analyzing Hedge Fund External Parties
33.4.1 Analyzing Hedge Fund Prime Brokers
33.4.2 Analyzing Hedge Fund Administrators
33.4.3 Independent Service Provider Verification of Fund Operational Data
33.5 Analyzing Hedge Fund Compliance Considerations
33.5.1 Personal Trading of Fund Employees
33.5.2 Common Compliance Risks Regarding Personal Trading
33.5.3 Compliance Risks Regarding Insider Trading
33.5.4 Electronic Communication Monitoring
33.5.5 Analyzing the Work of Third-Party Compliance Consultants
33.6 Documenting the Operational Due Diligence Process
33.7 Operational Decision Making and Allocation Considerations
33.8 Investigative Due Diligence
33.8.1 Three Models of Selecting Personnel for Investigation
33.8.2 Five Areas of Background Investigation
33.8.3 Factors in Organizing and Interpreting an Investigation
33.9 Four Approaches to Resource Allocation for Operational Due Diligence
33.10 Hedge Fund Governance
33.11 Hedge Fund Insurance
33.12 Performing Operational Due Diligence on Funds of Hedge Funds
33.13 Conclusion
CHAPTER 34. Regulation and Compliance
34.1 Three Foundational Principles of Financial Market Regulation
34.2 The Regulation of Alternative Investments within the United States
34.2.1 Legal Foundation of Regulation of Hedge Funds in the United States
34.2.2 Regulation of Hedge Funds in the United States
34.2.3 Hedge Fund Registration in the United States
34.2.4 Compliance Culture and Policies and Procedures in the United States
34.2.4.1 Duties of the Chief Compliance Officer
34.2.4.2 Code of Ethics
34.2.4.3 Three Types of SEC Inspections
34.2.4.4 Aftermath of an SEC Inspection
34.2.5 Various Reporting Requirements for Hedge Funds in the United States
34.2.6 An Overview of Private Equity Fund Regulation in the United States
34.3 Alternative Investment Regulation in Europe
34.3.1 A Brief Historical View of the European Union
34.3.2 An Overview of Regulations for Alternative Asset Managers in Europe
34.3.3 Registration and Exemptions in European Regulation
34.3.3.1 Registration in European Regulation
34.3.3.2 Exemptions to Compliance in European Regulation
34.3.3.3 Obtaining Registration in European Regulation
34.3.3.4 AIFMD Fund Directives and Fund Requirements
34.3.3.5 Marketing Materials in European Regulation
34.3.3.6 Formal Risk Management and Accountability in European Regulation
34.3.3.7 Required Reporting in European Regulation
34.3.4 Enforcement of European Regulation
34.3.4.1 The Role of the European Securities and Markets Authority
34.3.4.2 Penalties in European Regulation
34.3.4.3 The Enforcement Role of ESMA
34.3.5 Non-EU Managers in Europe
34.4 Hedge Fund Regulation in Asia
34.4.1 Hong Kong
34.4.2 Singapore
34.4.3 South Korea
34.4.4 Japan
34.4.5 Summary of Asian Hedge Fund Regulation
34.5 Conclusion
Part 6. Structured Products
CHAPTER 35. Structured Products I: Fixed-Income Derivatives and Asset-Backed Securities
35.1 Overview of Term Structure Modeling
35.2 Equilibrium Models of the Term Structure
35.2.1 Vasicek's Model and Short-Term Interest Rates
35.2.2 Vasicek's Model and the Term Structure of Interest Rates
35.2.3 Robustness of Vasicek's Model of the Term Structure of Interest Rates
35.2.4 The Cox, Ingersoll, and Ross Model of Interest Rates
35.3 Arbitrage-Free Models of the Term Structure
35.3.1 The Ho and Lee Model of Interest Rates
35.3.2 The Ho and Lee Model in a Binomial Framework
35.3.3 Evaluation of the Ho and Lee Model of Interest Rates
35.4 Interest Rate Derivatives
35.4.1 Interest Rate Caps and Floors
35.4.2 Callable Bonds
35.4.3 Interest Rate Swaps
35.4.4 Valuation of an Interest Rate Swap
35.4.5 Risks Associated with Interest Rate Swaps
35.4.5.1 Credit Risk
35.4.5.2 Interest Rate Risk
35.4.5.3 The Situation after the Financial Crisis of 2007–8
35.5 Asset-Backed Securities
35.6 Auto Loan–Backed Securities
35.7 Credit Card Receivables
35.8 Conclusion
References
CHAPTER 36. Structured Products II: Insurance-Linked Products and Hybrid Securities
36.1 Insurance-Linked Securities
36.2 Overview of Non-Life ILS: Catastrophe Bonds
36.2.1 Mechanics of Non-Life ILS: Catastrophe Bonds
36.2.2 Four Trigger Types of Cat Bonds
36.2.3 Cat Bond Performance
36.2.4 Establishing the Coupon Rate to Investors in Cat Bonds
36.3 Life ILS: Longevity and Mortality Risk–Related Products
36.3.1 Longevity Risk
36.3.2 Hedging Longevity Risk
36.3.3 Mortality Risk334
36.3.4 Overview of Life Insurance Settlements
36.3.5 Modeling Life Insurance Settlements
36.3.6 Overview of Viatical Settlements
36.3.7 Investment Benefits and Risks of Viatical Settlements
36.4 Hybrid Products: Mezzanine Debt
36.4.1 Overview of Mezzanine Finance
36.4.2 Benefits and Disadvantages of Mezzanine Debt to Issuers and Investors
36.4.3 Terms and Yields of Mezzanine Debt
36.4.4 Mezzanine Products
36.4.4.1 Subordinated Debt with Step-Up Rates
36.4.4.2 Subordinated Debt with PIK Interest
36.4.4.3 Subordinated Debt with Profit Participation
36.4.4.4 Subordinated Debt with Warrants
36.4.4.5 Convertible Loans
36.4.5 Mezzanine Financing and Project Finance
36.5 Conclusion
References
APPENDIX A. Alternative Presentations of Mean-Variance Optimization
Index
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where μ is the expected return on the portfolio, λ is a parameter that represents the risk-aversion of the asset owner, and σ2 is the variance of the portfolio's return. The next section provides a more detailed description of this portfolio construction technique and examines the solution under some specific conditions. Later sections will discuss some of the problems associated with this portfolio optimization technique and offer some of the solutions that have been proposed by academic and industry researchers.
The portfolio construction problem discussed in this section is the simplest form of mean-variance optimization. The universe of risky investments available to the portfolio manager consists of N asset classes. The single-period total rate of return on the risky asset i is denoted by Ri, for i = 1, … N. We assume that asset zero is riskless, and its rate of return is given by R0. The weight of asset i in the portfolio is given by wi. Therefore, the rate of return on a portfolio of the N + 1 risky and riskless asset can be expressed as:
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