Alternative Investments: CAIA Level I

Praise for
Alternative Investments
CAIA Level 1
THIRD EDITION

"By reading CAIA′s Alternative Investments: CAIA Level I, an aspiring investment analyst can quickly get up to speed on all foundational concepts of alternative investments. As a result, CAIA′s book is a wonderful foundation of knowledge for anyone coming into the alternative investments industry."
Hilary Till, Principal, Premia Capital Management, LLC; Co–Editor, Intelligent Commodity Investing

"Alternatives such as hedge funds, private equity, and real estate are an increasingly critical part of the investment portfolios of family offices, pensions, and other institutions. Yet many features of these asset classes remain shrouded in mystery. This book provides a broad yet thoughtful introduction to the spectrum of alternative investments."
Josh Lerner, Jacob H. Schiff Professor of Investment Banking, Harvard Business School

"The CAIA Association has set a new bar for excellence in alternative investments. Alternative Investments: CAIA Level 1 is an absolutely invaluable asset no matter what level of experience you have with alternative investments. The second edition currently sits on my desk, with dozens of sticky notes peeking out."
Daniel Kerbach, CAIA, Head Global Portfolio Management, Julius Baer Group

"CAIA is the leader in alternatives education and Deutsche Asset & Wealth Management is proud to endorse its third edition of the Level I textbook. Alternative investments can be a critical component of client portfolios. In a time of market uncertainty, demographic changes, and enhanced regulatory requirements, we believe that a greater understanding of alternative investments is essential before they can be integrated into institutional and private portfolios. This book fills that important need."
Theresa Gusman, Managing Director/Chief Knowledge Officer, Deutsche Asset & Wealth Management

Preface

Acknowledgments

About the Authors

Part 1: Introduction to Alternative Investments

Chapter 1: What Is an Alternative Investment?

1.1 Alternative Investments by Exclusion

1.2 Alternative Investments by Inclusion

1.3 Structures among Alternative Investments

1.4 Investments Are Distinguished by Return Characteristics

1.5 Investments Are Distinguished by Methods of Analysis

1.6 Investments Are Distinguished by Other Factors

1.7 Goals of Alternative Investing

1.8 Overview of This Book

Review Questions

Chapter 2: The Environment of Alternative Investments

2.1 The Participants

2.2 Financial Markets

2.3 Regulatory Environment

2.4 Liquid Alternative Investments

2.5 Taxation

Review Questions

Notes

Chapter 3: Quantitative Foundations

3.1 Return and Rate Mathematics

3.2 Returns Based on Notional Principal

3.3 Internal Rate of Return

3.4 Problems with Internal Rate of Return

3.5 Distribution of Cash Waterfall

Review Questions

Chapter 4: Statistical Foundations

4.1 Return Distributions

4.2 Moments of the Distribution: Mean, Variance, Skewness, and Kurtosis

4.3 Covariance, Correlation, Beta, and Autocorrelation

4.4 Interpreting Standard Deviation and Variance

4.5 Testing for Normality

4.6 Time–Series Return Volatility Models

Review Questions

Chapter 5: Measures of Risk and Performance

5.1 Measures of Risk

5.2 Estimating Value at Risk (VaR)

5.3 Ratio–Based Performance Measures

5.4 Risk–Adjusted Return Measures

Review Questions

Note

Chapter 6: Foundations of Financial Economics

6.1 Informational Market Efficiency

6.2 Single–Factor and Ex Ante Asset Pricing

6.3 Multifactor and Empirical Models

6.4 Arbitrage–Free Models

6.5 The Term Structure of Forward Contracts

6.6 Option Exposures

6.7 Option Pricing Models

6.8 Option Sensitivities

Review Questions

Notes

Chapter 7: Benchmarking and Performance Attribution

7.1 Benchmarking

7.2 Types of Models

7.3 Performance Attribution

7.4 Distinctions Regarding Alternative Asset Benchmarking

Review Questions

Notes

Chapter 8: Alpha, Beta, and Hypothesis Testing

8.1 Overview of Beta and Alpha

8.2 Ex Ante versus Ex Post Alpha

8.3 Inferring Ex Ante Alpha from Ex Post Alpha

8.4 Return Attribution, Alpha, and Beta

8.5 Ex Ante Alpha Estimation and Return Persistence

8.6 Return Drivers

8.7 Using Statistical Methods to Locate Alpha

8.8 Sampling and Testing Problems

8.9 Statistical Issues in Analyzing Alpha and Beta

Review Questions

Notes 

Chapter 9: Regression, Multivariate, and Nonlinear Methods

9.1 Single–Factor Models and Regression

9.2 Multifactor Models and Regression

9.3 Three Dynamic Risk Exposure Models

9.4 Two Approaches to Modeling Changing Correlation

9.5 Four Multifactor Approaches to Understanding Hedge Fund Returns

9.6 Evidence on Fund Performance Persistence

Review Questions

Notes

Part 2: Real Assets

Chapter 10: Natural Resources and Land

10.1 Natural Resources Other Than Land

10.2 Land

10.3 Timber and Timberland

10.4 Farmland

10.5 Valuation and Volatility of Real Assets

10.6 Historical Risks and Returns

Review Questions

Notes

Chapter 11: Commodity Forward Pricing

11.1 Forward Contracts versus Futures Contracts

11.2 Rolling Contracts

11.3 The Term Structure of Forward Prices on Commodities

11.4 Backwardation and Contango

11.5 Returns on Forward Contracts

Review Questions

Chapter 12: Commodities: Applications and Evidence

12.1 Commodity Investing for Diversification

12.2 Commodity Investing for Return Enhancement

12.3 Investing in Commodities without Futures

12.4 Commodity Exposure through Futures Contracts

12.5 Commodity Futures Indices

12.6 Commodity Risks and Returns

12.7 Historical Risks and Returns

Review Questions

Chapter 13: Operationally Intensive Real Assets

13.1 Commodity Producers

13.2 Liquid Alternative Real Assets

13.3 Infrastructure

13.4 Intellectual Property

Review Questions

Notes

Chapter 14: Liquid and Fixed–Income Real Estate

14.1 Real Estate as an Investment

14.2 Residential Mortgages

14.3 Commercial Mortgages

14.4 Mortgage–Backed Securities Market

14.5 Liquid Alternatives: Real Estate Investment Trusts

14.6 Historical Risks and Returns of Mortgage REITs

Review Questions

Notes

Chapter 15: Real Estate Equity Investments

15.1 Real Estate Development

15.2 Valuation and Risks of Real Estate Equity

15.3 Alternative Real Estate Investment Vehicles

15.4 Real Estate and Depreciation

15.5 Real Estate Equity Risks and Returns

15.6 Historical Risks and Returns of Equity REITs

Review Questions

Part 3: Hedge Funds

Chapter 16: Structure of the Hedge Fund Industry

16.1 Distinguishing Hedge Funds

16.2 Hedge Fund Fees

16.3 Hedge Fund Types

16.4 Hedge Fund Returns and Asset Allocation

16.5 Evaluating a Hedge Fund Investment Program

16.6 Do Hedge Funds Adversely Affect the Financial Markets?

16.7 Hedge Fund Indices

16.8 Conclusion

Review Questions

Notes

Chapter 17: Macro and Managed Futures Funds

17.1 Major Distinctions between Strategies

17.2 Global Macro

17.3 Returns of Macro Investing

17.4 Managed Futures

17.5 Systematic Trading

17.6 Systematic Trading Strategies

17.7 Evidence on Managed Futures Returns

17.8 Analysis of Historical Returns Conclusion

Review Questions

Notes

Chapter 18: Event–Driven Hedge Funds

18.1 The Sources of Most Event Strategy Returns

18.2 Activist Investing

18.3 Merger Arbitrage

18.4 Distressed Securities Funds

18.5 Event–Driven Multistrategy Funds

Review Questions

Notes

Chapter 19: Relative Value Hedge Funds

19.1 Overview of Relative Value Strategies

19.2 Convertible Bond Arbitrage

19.3 Volatility Arbitrage

19.4 Fixed–Income Arbitrage

19.5 Relative Value Multistrategy Funds

Review Questions

Notes

Chapter 20: Equity Hedge Funds

20.1 Sources of Return

20.2 Market Anomalies

20.3 The Fundamental Law of Active Management

20.4 Implementing Anomaly Strategies

20.5 The Three Equity Strategies

20.6 Equity Hedge Fund Risks

Review Questions

Notes

Chapter 21: Funds of Hedge Funds

21.1 Overview of Funds of Hedge Funds

21.2 Investing in Multistrategy Funds

21.3 Investing in Funds of Hedge Funds

21.4 Investing in Portfolios of Single Hedge Funds

21.5 Multialternatives and Other Hedge Fund Liquid Alternatives

21.6 Historical Returns of Funds of Funds

Review Questions

Notes

Part Four: Private Equity

Chapter 22: Introduction to Private Equity

22.1 Private Equity Terminology and Background

22.2 Private Equity as Equity Securities

22.3 Private Equity as Debt Securities

22.4 Private Equity Liquid Alternatives

22.5 Trends and Innovations in Private Equity

Review Questions

Notes

Chapter 23: Equity Types of Private Equity

23.1 Contrasts between Venture Capital and Buyouts

23.2 The Underlying Businesses of Venture Capital

23.3 Venture Capital Funds

23.4 The Dynamics of Venture Capital

23.5 Venture Capital Risks and Returns

23.6 Types of Buyouts

23.7 Leveraged Buyout Details

Review Questions

Chapter 24: Debt Types of Private Equity

24.1 Mezzanine Debt

24.2 Distressed Debt

Review Questions

Part 5: Structured Products

Chapter 25: Introduction to Structuring

25.1 Overview of Financial Structuring

25.2 Major Types of Structuring

25.3 The Primary Economic Role of Structuring

25.4 Collateralized Mortgage Obligations

25.5 Structural Model Approach to Credit Risk

25.6 Introduction to Collateralized Debt Obligations

Review Questions

Note

Chapter 26: Credit Risk and Credit Derivatives

26.1 An Overview of Credit Risk

26.2 Reduced–Form Modeling of Credit Risk

26.3 Credit Derivatives Markets

26.4 Credit Default Swaps

26.5 Other Credit Derivatives

26.6 CDS Index Products

26.7 Five Key Risks of Credit Derivatives

Review Questions

Notes

Chapter 27: CDO Structuring of Credit Risk

27.1 Overview of CDO Variations

27.2 Balance Sheet CDOs and Arbitrage CDOs

27.3 Mechanics of and Motivations for an Arbitrage CDO

27.4 Cash–Funded CDOs versus Synthetic CDOs

27.5 Cash Flow CDOs versus Market Value CDOs

27.6 Credit Enhancements

27.7 Developments in CDOs

27.8 Risks of CDOs

Review Questions

Chapter 28: Equity–Linked Structured Products

28.1 Structured Products and Six Types of Wrappers

28.2 Four Potential Tax Effects of Wrappers

28.3 Structured Products with Exotic Option Features

28.4 Global Structured Product Cases

28.5 Structured Product Pricing

28.6 Motivations of Structured Products

Review Questions

Notes

Part 6: Risk Management and Portfolio Management

Chapter 29: Cases in Tail Events

29.1 Problems Driven by Market Losses

29.2 Trading Technology and Financial Crises

29.3 Failures Driven by Fraud

29.4 Four Major Lessons from Cases in Tail Events

Review Questions

Notes

Chapter 30: Investment Process, Operations, and Risk

30.1 Investment Strategy and Process

30.2 Investment Process and Market Risk

30.3 The Three Internal Fund Activities

30.4 Operational Risk

30.5 Controlling Operational Risk

30.6 Controlling Risk of Portfolios with Options

Review Questions

Note

Chapter 31: Due Diligence of Fund Managers

31.1 Due Diligence Evidence and Organization

31.2 Screening with Three Fundamental Questions

31.3 Structural Review

31.4 Strategic Review

31.5 Administrative Review

31.6 Performance Review

31.7 Portfolio Risk Review

31.8 Legal Review

31.9 Reference Review

31.10 Evidence on Operational Risk

Review Questions

Notes

Chapter 32: Portfolio Management, Alpha, and Beta

32.1 The Estimation of Alpha and Beta

32.2 The Separation of Alpha and Beta

32.3 Portable Alpha

32.4 Alpha, Beta, and Portfolio Allocation

Review Questions

Note

Appendix: Data Sources

Computations and Explanations

Index

DR. DONALD R. CHAMBERS, CAIA, is the Associate Director of Programs at the CAIA Association, the Walter E. Hanson/KPMG Professor of Finance at Lafayette College in Easton, Pennsylvania, and Chief Investment Officer of Biltmore Capital Advisors. Dr. Chambers previously served as the Director of Alternative Investments at Karpus Investment Management. He is a member of the editorial board of The Journal of Alternative Investments.

DR. MARK J. P. ANSON, CAIA, CFA, CPA, PhD, JD, is a member of the CAIA Board of Directors and the President and Chief Investment Officer of the Bass Family Office winner of the Family Office of the Year award for 2014 2015. Dr. Anson previously served as President and Executive Director of Investment Services at Nuveen Investments Inc., Chief Executive Officer of both the British Telecom Pension Scheme and its wholly owned asset management company in London, Hermes Pension Management Limited, and Chief Investment Officer at California Public Employees′ Retirement System. He has published over 100 research articles in professional journals, has won two Best Paper Awards, is the author of six financial textbooks, and sits on the editorial boards of several financial journals.

DR. KEITH H. BLACK, CAIA, is the Managing Director of Curriculum and Exams at the CAIA Association. He was previously an Associate at Ennis Knupp and, before that, an Assistant Professor at Illinois Institute of Technology. He is a member of the editorial board of The Journal of Alternative Investments.

DR. HOSSEIN KAZEMI, is a senior adviser to the CAIA Association. He is Michael and is Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts Amherst, the Director of the Center for International Securities & Derivatives Markets, a co–founder of the CAIA Association, and the Editor–in–Chief of The Journal of Alternative Investments, the official publication of the CAIA Association.