Alternative Investments

Open Ended Fund - fund stands ready to redeem shares at closing value at end of any day - fund provides liquidity.  Load is the fee at purchase or redemption.  Ongoing fees (annual).

Closed end fund - shares traded in secondary markets.  Liquidity provided by open market.  Issued slightly above value of underlying assets to serve as a premium for issuance costs.  Load/no load are NOT applicable here.  Redemption cost is just the commission charged on the sale and portion of the bid/ask spread for shares.

Net Asset Value = assets minus liabilities, on a per share basis

Open end - share price will always equal NAV (company is obligated to redeem at NAV)

Closed end - share price does not have to equal NAV - can be at premium or discount

Fees

• Fees are basically compensation for sales and marketing, but NOT for performance
• Annual ongoing fees go to cover management fees (largest), administrative, and distribution fees
• Expense ratio = operating expenses / average assets
• Fees can significantly impact performance
• Holding period is an important determinant of what impact fees will have

To find the most advantageous structure for a given time frame, see what happens to $10,000 invested at each type of investment.

Equity Investment Strategies

• Style - describes basic characteristics of underlying assets.  Growth vs. value, large cap vs. small cap etc.
• Sector - concentrates investments in a certain industry
• Index - strives to match the return of a particular stock index
• Global Fund - invest all over the world
• Stable Value Fund - short term govt securities, or other instruments with timely principal payments and a set interest rate

ETF - special type of fund.  Invests in a portfolio of stocks or bonds and is designed to mimic the performance of a specified index.   Trade in secondary market.  But legally they are very different from open end mutual funds in how they are created and redeemed.

• Unique feature - 'in kind' creation and redemption of shares.  "Authorized participants" have the ability to create new shares in the ETF by depositing with a trustee a portfolio of stocks that track the index.  Participant then receives new ETF shares from the trustee and can sell these shares in the open market.  Can also do the converse and redeem shares to the trustee in exchange for the underlying stocks.
• Advantages: 1) keeps market prices close to NAV (arbitrage mechanism) and 2) tax advantage for in-kind redemption - capital gains are not realized until sale.  That means existing fund shareholders don't incur a tax liability

Advantages of ETFs

• Diversification
• Similar to equity investments - can trade any time, can margin/short
• Risk management through access to indices where options are traded
• Investors know composition of investments at all times (published daily)
• Lower operating expenses than traditional funds (passively managed and no loads)
• In kind creation ensures NAV = share prices or close if liquid
• Less capital gains tax liability
• For some, dividends may be reinvested immediately as opposed to index funds where these may be delayed

Disadvantages

• Outside the US, fewer indices for ETFs to track - mid/low caps are underrepresented
• Ability to trade intraday might not be that big an asset
• For ETFs with low trading volume the bid/ask spread may be higher
• Larger investors may just directly invest in an index portfolio resulting in lower expenses and lower tax consequences

Risks of ETFs

• Market risk of the index tracked
• Might only invest in one part of the market
• Trading prices can differ from NAV depending on liquidity
• Tracking error risk - portfolio is not identical to index, so might not track perfectly
• ETFs that purchase derivatives have leverage risk as well as credit risk on derivatives
• International ETF's might have currency and country risk

Real Estate Investment.  Real estate = land plus any permanently attached fixture.  Each is unique.  Fairly illiquid.

• Outright Ownership - aka fee simple or free and clear equity - most straightforward form of investment.  Full ownership rights for an indefinite period.
• Leveraged Equity Position - same as outright but with a loan attached.
• Mortgages - investor is the holder of a mortgage loan and receives monthly principal and interest pmts of a borrower.  This is considered real estate investment because if the borrower defaults you have a home.
• Aggregation Vehicles - RELPs, commingled funds, and REITs

High transaction costs and management fees.  Investments can't be separated or moved.  Not comparable directly to other properties.

Some indexes are available that track appraisal value rather than market value - appraisal value is less volatile.  But may not be appropriate in portfolio mean-variance optimization.

Other indexes are based on REIT performance.  REITs have similar vol to stock indexes and very highly correlated, therefore REITs as diversification tools are not great.  REIT returns are also levered so the actual returns of underlying real estate is not what is being measured.

Ability to protect against inflation is probably the biggest concern.  Some types of real estate are better than others for this.

Valuation of Real Estate

• Cost Method - replacement cost of 'improvements' (use current construction costs) plus an estimate for the land.  Land is hard to value.  Market value may differ significantly from replacement cost depending on condition of the improvements.
• Sales Comparison Method - price of a similar property or properties from recent transactions.  Make adjustments for unique characteristics.  Cannot be used in an illiquid market without recent transactions.  Hedonic Approach is more detailed - use a regression model quantifying specific characteristics and then apply it to the property.
• Income Method - estimate net operating income (NOI = annual gross rental revenues - operating expenses) and divide by the market required rate of return.  Disadvantage is that it does not take into account changes in NOI or consider investor's tax implications.
• Discounted After Tax Cash Flow Model - uses tax rates.  NPV = PV of after tax cash flows discounted at investors IRR, minus equity portion of the investment.  Only those with positive expected NPV should be invested in.

Calculating NOI

• Multiply total potential rental revenue by occupancy and subtract operating costs
• Depreciation and financing costs are NOT factored in
• It is assumed that maintenance will keep the property in good condition and the value of property is independent of financing arrangements
• Taxes that you subtract are PROPERTY taxes, not income taxes

Hedonic approach

• Examples include proximity to downtown, vacancy rate, and building size
• Multiply these each through by your property's characteristics and you have the value

Income Approach

• Just take the NOI and divide it by the capitalization rate - super easy

After Tax Cash Flows, NPV and Yield

• Example: NOI is 197,500.  Investor buys building for 1,850,000, putting down 20% cash and financing the remainder with mortgage at 10%.  Annual pmts on mortgage are $156,997 and the interest portion is fully deductible for income tax purposes.  Marginal income tax rate is 28%.  Depreciation is 45,000 per year.  Calculate after tax cash flows, NPV and yield.

Interest pmt is amt borrowed (1,480,000) times 10% = $148,000.  After tax net income = NOI less depreciation and interest, net of taxes = (197,000 - 45,000 - 148,000) * (1 - 0.28) = $3,240.

Now to get to cash flow you need to add back depreciation and subtract principal portion of the mortgage.  This is 3,240 + 45,000 - (156,997 - 148,000) = 39,243.

NPV - lay out all cash flows and take the PV, then subtract off the initial equity investment

Yield - lay out all the cash flows and find the IRR

Venture Capital Investing

Private, non-exchange traded equity investments in a business venture.  LPs usually.  High returns, highly illiquid and highly risky.  Can invest at any point from initial planning to an established firm ready to go public.

Stages

• Seed stage - earliest, R&D
• Early stage - startup (complete product development) and first stage (transition to commercial production and sales of product)
• Formative stage - broad category, encompasses seed + early stage
• Later stage - sales are underway but company still private.  "Second Stage" means investing in a company that is producing and selling but not making income.  "Third Stage" means funding a major expansion of the company.  Mezzanine or Bridge financing enables the company to take the steps necessary to go public.
• Second and third stage are also called "expansion stage"
• "Balanced Stage" covers all stages from seed to later

Characteristics

• Illiquid
• Long term horizon
• Difficult to value
• Limited data on historical risk/return/competing assets and ideas
• Entrepreneurs don't always manage well
• Fund manager incentives must align incentives for performance, not size
• Market cycles and conditions are a main determinant of entrance and exit strategies
• Extensive operations analysis is crucial

Valuation is difficult.  Most important factors are payoff at exit, timing of exit, and probability of failure.   

Computing NPV of a VC Project:

• Calculate probability that the project succeeds to the end (multiply all conditional probabilities 1-p by each other)
• Calculate NPV under case of total success and NPV under case of total failure (lose all equity)
• Take probability weighted average NPV

Hedge Funds

• Large variety of classes that strive for absolute returns
• Means they simply seek to maximize returns in all market scenarios - not held to a specific benchmark or index
• Most are LPs, LLCs or offshore corporations
• Limited number of investors if you want to avoid regulation - usually minimum investment is $200,000 or more
• Base fee usually around 1% of assets, regardless of performance - second component, incentive fee, is paid based on actual returns.  Might only be paid if beyond some bench rate (e.g. risk free).
• Sometimes performance fees only paid after previous losses have been recouped
• High water provision - incentives only paid based on returns over the highest value achieved over the life of the fund
• These provisions might encourage managers to take on extra risk after periods of negative returns

Classes of Hedge Funds

• Long/Short funds - largest category.  Can take long and short, use leverage, and invest worldwide.  By definition they are NOT market neutral - seek profit from greater returns on long than on shorts.
• Market Neutral - long short funds that strive to hedge against general market moves.  Longs and shorts offset each other so the net effect is zero exposure to the market
• Global Macro - bet on the direction of markets, currencies, interest rates, or other.  Typically highly leveraged and rely heavily on derivatives.
• Event Driven - capitalize on some unique opportunity in the market and may involve investing in a distressed company or in a potential merger and acquisition situation

Funds of Funds - creating a fund which then invests in hedge funds

• Benefits - investors with limited capital can invest in a portfolio of hedge funds.  Single investors can invest in more than one fund.
• Disadvantages - fund of fund managers charge another fee on top of the HF fees.  Diversification decreases risk but also probably reward.  Managers might not be any better at selecting funds than you are.

Leverage in Hedge Funds

• Can use margin account, borrow external funds, or just use securities that only require posting margin rather than full pmt
• Risks involved in hedge funds
• Illiquidity
• Potential for mispricing (some assets are hard to value) - requires more cash for margin because broker dealers are conservative in their valuations
• Counterparty risk - broker dealer is involved in almost every transaction which exposes the fund to credit risk
• Settlement errors - counterparty might fail to deliver security as agreed on the settlement date
• Short Covering - might have to cover shorts and repurchase securities at a price higher than where they originally sold
• Margin calls - can result in forced selling of assets, possibly at a loss

Hedge Fund Performance

• Generally lower risk than traditional equity investments
• Higher Sharpe ratio (reward to risk) than traditional equities, and comparable to fixed income
• Low correlation between performance of HF's and conventional investments.  Correlation is lower in bad markets and higher in good markets.

Hedge fund performance biases

• Self-selection results in overestimation
• Backfilling - funds with poor past performance are not included
• Survivorship - only the good funds survive
• Smoothed pricing of infrequently traded assets - this reduces reported volatility
• Option like strategies - some strategies may have limited upside and unlimited downside.  Standard deviation and other traditional risk measures to not effectively account for assymetrical returns.
• Fee structures / gaming - fund managers may take big risks, due to comp structures

Effect of survivorship bias is greater for HF industry because there are no reporting standard requirements.  This means you overstate returns.  Opposite effect on risk measures - highly volatile funds tend to fail more frequently and defunct funds are not included.  Because database only includes more stable funds that have survived, risk measure of hedge funds is understated.

Closely Held Companies

These are not publicly traded.  Held by a small group of owners.  Do not have to report and disclose like normal SEC companies.  Can be any legal entity (LLC, Scorp, etc.).  Choice of structure affects investors rights/responsibilities and therefore value of their investments.

When litigation arises there can be disputes as to value.  Definitions of intrinsic, fundamental, and fair value may differ by jurisdiction and there are no market transactions.   Valuation is therefore cash flow based.  Both purpose of valuation and the jurisdiction affect decision factors for value.  Three approaches.

• Cost Approach - what is cost today to replace company's assets in their present state?
• Comparables Approach - base value on market prices of similar companies
• Income Approach - what is the NPV of discounted future cash flows?

To these base values, you might adjust for liquidity and marketability (discount further).  Might also need to discount if it is a minority interest and the benchmark is a controlling interest.  Conversely you might add a premium if the benchmark is a minority interest.

Distressed Investing

Similar to VC in terms of liquidity, time commitment, and involvement.

Commodities

Investing in commodities gives you exposure to an economy's production and consumption growth.  Swings in commodity prices are likely to be larger than swing in finished goods prices.

Motivation for investing in commodities is as an inflation protector or for near term speculation.  Passive investors will likely invest in a collateralized futures position.  This means taking a position in a future and pairing it with an investment in Treasuries equal to the value of the position.  Active investors might invest in futures to attempt to profit from economic growth.

Commodity linked equity investments (e.g. producers) are also strongly tied to commodity price changes.

Commodity linked bonds provide income as well as exposure.  Might be attractive to a fixed income investor who cannot invest in equities or commodities directly.

Sources of Return on a Collateralized Commodity Futures Position

Go long a specific futures contract, and purchase t-bills with a MARKET value equal to the CONTRACT value of the futures contract.  Any gains from the futures are used to buy more t-bills, and any margin calls are covered by selling t-bills.  Total return = percentage change in price of futures contract + percent interest earned on the T-bill.