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Alternative Investments. An Allocator's Approach. Edition No. 4

  • Book

  • 960 Pages
  • October 2020
  • John Wiley and Sons Ltd
  • ID: 5837639

Whether you are a seasoned professional looking to explore new areas within the alternative investment arena or a new industry participant seeking to establish a solid understanding of alternative investments, Alternative Investments: An Allocator's Approach, Fourth Edition (CAIA Level II curriculum official text) is the best way to achieve these goals.

In recent years, capital formation has shifted dramatically away from public markets as issuers pursue better financial and value alignment with ownership, less onerous and expensive regulatory requirements, market and information dislocation, and liberation from the short-term challenges that undergird the public capital markets. The careful and informed use of alternative investments in a diversified portfolio can reduce risk, lower volatility, and improve returns over the long-term, enhancing investors' ability to meet their investment outcomes. Alternative Investments: An Allocator's Approach (CAIA Level II curriculum official text) is a key resource that can be used to improve the sophistication of asset owners and those who work with them.

This text comprises the curriculum, when combined with supplemental materials available at caia.org, for the CAIA Level II exam.

"Over the course of my long career one tenet has held true, 'Continuing Education'. Since CalSTRS is a teachers' pension plan, it is no surprise that continuing education is a core attribute of our Investment Office culture. Overseeing one of the largest institutional pools of capital in the world requires a cohesive knowledge and understanding of both public and private market investments and strategies. We must understand how these opportunities might contribute to delivering on investment outcomes for our beneficiaries. Alternative Investments: An Allocator's Approach is the definitive core instruction manual for an institutional investor, and it puts you in the captain's chair of the asset owner."
- Christopher J. Ailman, Chief Investment Officer, California State Teachers’ Retirement System

"Given their diversified cash flow streams and returns, private markets continue to be a growing fixture of patient, long-term portfolios. As such, the need to have proficiency across these sophisticated strategies, asset classes, and instruments is critical for today's capital allocator. As a proud CAIA charterholder, I have seen the practical benefits in building a strong private markets foundation, allowing me to better assist my clients."
- Jayne Bok, CAIA, CFA, Head of Investments, Asia, Willis Tower Watson

Table of Contents

Preface xxxix

Acknowlegements xli

About the Authors xlv

Part 1 Ethics Regulations and ESG

Chapter 1 Asset Manager Code 3

1.1 General Principles of Conduct 3

1.2 Asset Manager Code 3

1.3 Notification of Compliance 5

1.4 Additional Guidance for the Asset Manager Code 6

Chapter 2 Recommendations and Guidance 11

Chapter 3 Global Regulation 27

3.1 Overview of Financial Market Regulation 27

3.2 Regulation of Alternative Investments Within the United States 28

3.3 Alternative Investment Regulation in Europe 38

3.4 Hedge Fund Regulation in Asia 45

Chapter 4 ESG and Alternative Investments 49

4.1 Background on ESG and Alternative Investing 49

4.2 ESG and Real Assets: Natural Resources 51

4.3 ESG and Real Assets: Commodities 53

4.4 ESG and Real Assets: Real Estate 55

4.5 ESG and Hedge Funds 61

4.6 ESG and Private Equity 66

Chapter 5 ESG Analysis and Application 71

5.1 Background on ESG 71

5.2 ESG Ratings and Scores 73

5.3 ESG Materiality and Disclosure 74

5.4 The United Nations Role in ESG Issues 76

5.5 ESG Fiduciary Responsibilities and Regulation 78

5.6 Methods of ESG Investing 80

5.7 Market-Based Methods of Addressing ESG Issues 85

5.8 ESG and Special Investment Consideration 87

Part 2 Models

Chapter 6 Modeling Overview and Interest Rate Models 93

6.1 Types of Models Underlying Investment Strategies 93

6.2 Equilibrium Fixed-Income Models 96

6.3 Arbitrage-Free Models of the Term Structure 99

6.4 The Black-Derman-Toy Model 100

6.5 P-Measures and Q-Measures 103

Chapter 7 Credit Risk Models 105

7.1 The Economics of Credit Risk 105

7.2 Overview of Credit Risk Modeling 109

7.3 The Merton Model 110

7.4 Other Structural Models: KMV 117

7.5 Reduced-Form Models 120

7.6 Empirical Credit Models 123

Chapter 8 Multi-Factor Equity Pricing Models 127

8.1 Multi-Factor Asset Pricing Models 127

8.2 FAMA-French Models 131

8.3 Three Challenges of Empirical Multi-Factor Models 133

8.4 Factor Investing 135

8.5 The Adaptive Markets Hypothesis 141

8.6 Time-Varying Volatility 142

8.7 Stochastic Discount Factors 143

8.8 Summary of Multiple-Factor Asset Allocation 145

Chapter 9 Asset Allocation Processes and the Mean-Variance Model 147

9.1 Asset Allocation Processes and the Mean-Variance Model 147

9.2 Implementation of Mean-Variance Optimization 155

9.3 Mean-Variance Optimization with Multiple Risky Assets 160

9.4 Mean-Variance Optimization and Hurdle Rates 162

9.5 Issues in Using Optimization for Portfolio Selection 163

9.6 Adjustment of the Mean-Variance Approach for Illiquidity 166

9.7 Adjustment of the Mean-Variance Approach for Factor Exposure 168

9.8 Mitigating Estimation Error Risk in Mean-Variance Optimization 168

Chapter 10 Other Asset Allocation Approaches 175

10.1 The Core-Satellite Approach 175

10.2 Top-Down and Bottom-Up Asset Allocation Approaches 176

10.3 Risk Budgeting 178

10.4 A Factor-Based Example of Implementing A Risk Budgeting Approach 181

10.5 Risk Parity 183

10.6 Other Quantitative Portfolio Allocation Strategies 189

10.7 The New Investment Model 193

Part 3 Institutional Asset Owners and Investment Policies

Chapter 11 Types of Asset Owners and the Investment Policy Statement 197

11.1 Endowments and Foundations 197

11.2 Pension Funds 198

11.3 Sovereign Wealth Funds 199

11.4 Family Offices 199

11.5 Strategic Asset Allocation: Risk and Return 199

11.6 Asset Allocation Objectives 202

11.7 Investment Policy Constraints 202

11.8 Investment Policy Statements for Institutional Asset Owners 204

Chapter 12 Foundations and the Endowment Model 221

12.1 Defining Endowments and Foundations 221

12.2 Intergenerational Equity, Inflation, and Spending Challenges 224

12.3 The Endowment Model 226

12.4 Why Might Large Endowments Outperform? 228

12.5 Risks of the Endowment Model 234

12.6 Liquidity Rebalancing and Tactical Asset Allocation 239

12.7 Tail Risk 240

12.8 Conclusion 242

Chapter 13 Pension Fund Portfolio Management 245

13.1 Development, Motivations, and Types of Pension Plans 245

13.2 Risk Tolerance and Asset Allocation 247

13.3 Defined Benefit Plans 251

13.4 Governmental Social Security Plans 258

13.5 Contrasting Defined Benefit and Contribution Plans 259

13.6 Annuities for Retirement Income 262

13.7 Conclusion 266

Chapter 14 Sovereign Wealth Funds 269

14.1 Sources of Sovereign Wealth 269

14.2 Four Types of Sovereign Wealth Funds 272

14.3 Establishment and Management of Sovereign Wealth Funds 274

14.4 Governance and Political Risks of SWFs 277

14.5 Analysis of Three Sovereign Wealth Funds 279

14.6 Conclusion 282

Chapter 15 Family Offices and the Family Office Model 285

15.1 Identifying Family Offices 285

15.2 Goals, Benefits, and Business Models of Family Offices 286

15.3 Family Office Goals by Generations 290

15.4 Macroeconomic Exposures of Family Offices 295

15.5 Income Taxes of Family Offices 297

15.6 Lifestyle Assets of Family Offices 300

15.7 Family Office Governance 304

15.8 Charity, Philanthropy, and Impact Investing 307

15.9 Ten Competitive Advantages of Family Offices 310

Part 4 Risk and Risk Management

Chapter 16 Cases in Tail Risk 315

16.1 Problems Driven by Market Losses 315

16.2 Trading Technology and Financial Crises 324

16.3 Failures Driven by Fraud 326

16.4 Four Major lessons From cases in Tail Events 334

Chapter 17 Benchmarking and Performance Attribution 337

17.1 Benchmarking and Performance Attribution Overview 337

17.2 Single-Factor Benchmarking and Performance Attribution 340

17.3 Multi-Factor Benchmarking 344

17.4 Distinctions Regarding Alternative Asset Benchmarking 346

17.5 Benchmarking of Commodities 348

17.6 Three Approaches to Benchmarking Managed Futures Funds 351

17.7 Benchmarking Private Equity Funds 352

17.8 Group Peer Returns as Benchmarks 357

17.9 Benchmarking Real Estate 358

Chapter 18 Liquidity and Funding Risks 363

18.1 Margin Accounts and Collateral Management 363

18.2 Value at Risk for Managed Futures 367

18.3 Other Methods of Estimating Liquidity Needs 369

18.4 Smoothed Returns on Illiquid Funds 373

18.5 Modeling Price and Return Smoothing 375

18.6 Unsmoothing a Hypothetical Return Series 378

18.7 Unsmoothing Actual Real Estate Return Data 380

Chapter 19 Hedging, Rebalancing, and Monitoring 389

19.1 Managing Alpha and Systematic Risk 389

19.2 Managing the Risk of a Portfolio with Options 391

19.3 Delta-Hedging of Option Positions 394

19.4 Three Key Observations on Delta-Hedging 399

19.5 Three Observations on Rebalancing Delta-Neutral Option Portfolios 400

19.6 Rebalancing Portfolios with Directional Exposures 401

19.7 Mean-Reversion and Diversification Return 407

19.8 Investment Monitoring 409

Chapter 20 Risk Measurement, Risk Management, and Risk Systems 413

20.1 Overview of Risk Measurement and Aggregation 413

20.2 Categories of Information to be Considered 422

20.3 Risk Measurement with Daily Frequency of Data Collection 424

20.4 Risk Measurement with Weekly Frequency of Data Collection 425

20.5 Risk Measurement with Monthly Frequency of Data Collection 426

20.6 Risk Measurement with Quarterly Frequency of Data Collection 427

20.7 Risk Measurement with Annual Frequency of Data Collection or Rolling Time Periods 427

20.8 Cybersecurity for Fund Managers 429

20.9 Risk Management Structure and Process 432

Part 5 Methods for Alternative Investing

Chapter 21 Valuation and Hedging Using Binomial Trees 439

21.1 A One-Period Binomial Tree and Risk-Neutral Modeling 439

21.2 Multi-Period Binomial Trees, Values, and Mean Rates 442

21.3 Valuation of Convertible Securities with a Binomial Tree Model 445

21.4 Valuing Callable Bonds with a Tree Model 452

21.5 Tree Models, Visualization, and Two Benefits to Spreadsheets 458

Chapter 22 Directional Strategies and Methods 459

22.1 Efficiently Inefficient Markets 459

22.2 Technical Directional Strategies Overview 460

22.3 Fundamental Directional Strategies 467

22.4 Directional Strategies and Behavioral Finance 473

22.5 Directional Trading and Factors 476

Chapter 23 Multivariate Empirical Methods and Performance Persistence 479

23.1 Statistical Factors and Principal Component Analysis 479

23.2 Multi-Factor Models and Regression 483

23.3 Partial Autocorrelations and Regression 485

23.4 Three Dynamic Risk Exposure Models 487

23.5 Two Approaches to Modeling Changing Correlation 489

23.6 Four Multi-Factor Approaches to Understanding Returns 493

23.7 Evidence on Fund Performance Persistence 496

Chapter 24 Relative Value Methods 499

24.1 Overview of Relative Value Methods 499

24.2 Types of Pairs Trading and the Four Typical Steps 502

24.3 Statistical Pairs Trading of Equities 503

24.4 Pairs Trading in Commodity Markets Based on Spreads 506

Chapter 25 Valuation Methods for Private Assets: The Case of Real Estate 519

25.1 Depreciation Tax Shields 519

25.2 Deferral of Taxation of Gains 522

25.3 Comparing After-Tax Returns for Various Taxation Scenarios 524

25.4 Transaction-Based Indices: Repeat-Sales 529

25.5 Transaction-Based Indices: Hedonic 532

25.6 Sample Bias and the Repeat-Sales and Hedonic-Price Methods 535

25.7 Appraisal-Based Indices 536

25.8 Noisy Pricing 537

Part 6 Accessing Alternative Investments

Chapter 26 Hedge Fund Replication 543

26.1 An Overview of Replication Products 543

26.2 Potential Benefits of Replication Products 544

26.3 The Case for Hedge Fund Replication 545

26.4 Unique Benefits of Replication Products 549

26.5 Factor-Based Approach to Replication 552

26.6 The Algorithmic (Bottom-Up) Approach 558

26.7 Three Illustrations of the Algorithmic (Bottom-Up) Approach 558

Chapter 27 Diversified Access to Hedge Funds 565

27.1 Evidence Regarding Hedge Fund Risk and Returns 565

27.2 Approaches to Accessing Hedge Funds 569

27.3 Characteristics of Funds of Hedge Funds 573

27.4 Fund of Hedge Funds Portfolio Construction 577

27.5 Ways that Funds of Hedge Funds Can Add Value 580

27.6 Investable Hedge Fund Indices 584

27.7 Alternative Mutual Funds 585

Chapter 28 Access to Real Estate and Commodities 589

28.1 Unlisted Real Estate Funds 589

28.2 Listed Real Estate Funds 594

28.3 Commodities 598

28.4 Commodity Trade Financing and Production Financing 606

28.5 Leveraged and Option-Based Structured Commodity Exposures 606

28.6 Key Concepts in Managing Commodity Exposure 609

Chapter 29 Access Through Private Structures 613

29.1 Overview of Issues in Private Versus Listed Investment Access 613

29.2 Unlisted Manager-Investor Relationships 616

29.3 Side Letters to Limited Partnership Agreements 619

29.4 Co-Investments 621

29.5 Cash Commitments and Illiquidity 626

29.6 The Secondary Market for PE Partnerships 629

Chapter 30 The Risk and Performance of Private and Listed Assets 637

30.1 Evidence on an Illiquidity Premium from Listed Assets 637

30.2 Private Versus Listed Real Performance: The Case of Real Estate 639

30.3 Challenges with the PME Method to Evaluating Private Asset Performance 641

30.4 Multiple Evaluation Tools 648

30.5 IRR Aggregation Problems for Portfolios 653

30.6 The Case Against Private Equity 657

30.7 Two Propositions Regarding Access Through Private Versus Listed Structures 658

Part 7 Due Diligence & Selecting Managers

Chapter 31 Active Management and New Investments 663

31.1 Tactical Asset Allocation 663

31.2 The Fundamental Law of Active Management 664

31.3 Costs of Actively Reallocating Across Alternative Investments 667

31.4 Keys to a Successful Tactical Asset Allocation Process 670

31.5 Adjusting Exposures to Illiquid Partnerships 674

31.6 The Secondary Market for PE LP Interests 676

Chapter 32 Selection of a Fund Manager 683

32.1 The Importance of Fund Selection Across Managers Through Time 683

32.2 The Relationship Life Cycle Between LPs and GPs 683

32.3 Fund Return Persistence 688

32.4 Moral Hazard, Adverse Selection, and the Holdup Problem in Fund Management 694

32.5 Screening with Fundamental Questions 694

32.6 Historical Performance Review 698

32.7 Manager Selection and Deal Sourcing 703

32.8 Fund Culture 705

32.9 Decision-Making and Commitment and Manager Selection 706

Chapter 33 Investment Process Due Diligence 709

33.1 Overview of Investment Due Diligence 709

33.2 The Investment Strategy or Mandate 712

33.3 The Investment Implementation Process and its Risks 715

33.4 Asset Custody and Valuation 717

33.5 Risk Alert’s One Advantage and Six Observations on Third-Party Information 723

33.6 Portfolio Risk Review 725

33.7 Four Warning Indicators and Awareness Signals Regarding Investments 729

33.8 Four Warning Indicators and Awareness Signals Regarding Risk Management 729

Chapter 34 Operational Due Diligence 731

34.1 Operations: Overview, Risks, and Remedies 731

34.2 Four Key Operational Activities 735

34.3 Analyzing Fund Cash Management and Movement 737

34.4 Analyzing External Parties and Checking Principals 739

34.5 Analyzing Fund Compliance 743

34.6 Onsite Manager Visits 747

34.7 Elements and Key Concerns of the Odd Process 748

34.8 Information Technology and Meta Risks 749

34.9 Funding, Applying, and Concluding ODD 750

Chapter 35 Due Diligence of Terms and Business Activities 755

35.1 Due Diligence Document Collection Process 755

35.2 Fund Governance 757

35.3 Structural Review of the Fund And Fund Manager 758

35.4 Terms for Liquid Private Funds 761

35.5 Terms for Illiquid Private Funds 763

35.6 General Terms for Private Funds 764

35.7 Private Placement Memorandum (PPM) 765

35.8 Fund Fees and Expenses 769

35.9 Private Fund Audited Financial Statement Review 771

35.10 Business Activities, Continuity Planning, Disaster Recovery, and Insurance 773

Part 8 Volatility and Complex Strategies

Chapter 36 Volatility as a Factor Exposure 779

36.1 Measures of Volatility 779

36.2 Volatility and the Vegas, Gammas, and Thetas of Options 781

36.3 Exposures to Volatility as a Factor 785

36.4 Modeling Volatility Processes 791

36.5 Implied Volatility Structures 794

Chapter 37 Volatility, Correlation, and Dispersion Products and Strategies 799

37.1 Common Option Strategies and their Volatility Exposures 799

37.2 Volatility and Delta-Neutral Portfolios with Options 803

37.3 Advanced Option-Based Volatility Strategies 805

37.4 Variance-Based and Volatility-Based Derivative Products 807

37.5 Correlation Swaps 815

37.6 Dispersion Trades 818

37.7 Summary and Common Themes of Volatility, Correlation, and Dispersion Trading 819

Chapter 38 Complexity and Structured Products 825

38.1 Uncertainty, Ambiguity, and Opacity 825

38.2 Asset and Strategy Complexity 827

38.3 Cases in Complexity and Perverse Incentives 828

38.4 Asset-Based Lending 831

38.5 Risks of Asset-Based Loans 836

38.6 Asset-Backed Securities 838

Chapter 39 Insurance-Linked Products and Hybrid Securities 845

39.1 Nonlife ILS: Catastrophe Bonds 845

39.2 Four Trigger Types of Cat Bonds 847

39.3 Cat Bond Valuation, Performance, and Drawbacks 849

39.4 Longevity and Mortality Risk-Related Products 852

39.5 Life Insurance Settlements 855

39.6 Overview of Viatical Settlements 857

39.7 Hybrid Products: Mezzanine Debt 859

Chapter 40 Complexity and the Case of Cross-Border Real Estate Investing 865

40.1 Traditional View of Currency-Hedging for Cross-Border Real Estate Investing 865

40.2 Fundamentals of Currency Risk And Hedging in Perfect Markets 870

40.3 Currency Risk and Hedging of Alternative Investments 873

40.4 Accessing Foreign Assets with Futures and Quanto Futures 876

40.5 Overview of International Real Estate Investing 879

40.6 Heterogenous Investment Taxation Across Jurisdictions 881

40.7 Challenges to International Real Estate Investing 882

Index 887 

Authors

Donald R. Chambers Lafayette College in Easton, PA. Hossein B. Kazemi University of Massachusetts, Amherst, MA. Keith H. Black Illinois Institute of Technology.