Alternative Investments

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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