Alternative Investments

Professor Dr. Marcel Prokopczuk, CFA

Outline
• This is a 10 credit module
• We have 10h of lectures and 4h of seminars
• Assessment is by final exam (60min)
• We cover material of the CAIA Level I
• Main reference (ISBN: 978-1119604143)
• The teaching assistant is Mininder Sethi
[email protected]

Prof. Dr. Marcel Prokopczuk Alternative Investments 2

Content
I. Introduction to Alternative Investments
II. Natural Resources and Land
III. Commodities
IV. Real Estate
V. Hedge Funds

Remark: The CAIA curriculum additionally contains private equity and structured products. These topics are covered in
separate modules at the ICMA Centre

Prof. Dr. Marcel Prokopczuk Alternative Investments 3

I. Introduction to Alternative Investments

Prof. Dr. Marcel Prokopczuk Alternative Investments 4

What is an Alternative Investment?
• There is no unique definition for “alternative” investments
• One way to define alternative investments is by exclusion, i.e. all
investments that are non-traditional (stocks, fixed-income securities,
cash)
• But “investment” is a very broad concept (deferred consumption)
• In that sense, many things would be an “alternative investment”, e.g.
university education
• The CAIA (and many others) focus on “institutional-quality”
investments, i.e. something a pension fund would invest into

Prof. Dr. Marcel Prokopczuk Alternative Investments 5

Alternative Assets
• Another way is to define alternative investments by inclusion:
1. Real assets (natural resources, commodities, real estate,
infrastructure and intellectual property)
2. Hedge funds (including managed futures)
3. Private equity (and private debt)
4. Structured products (including credit derivatives)
5. Others (art, collectibles, wine, ships and aircrafts, crypto-assets,
crowd-investing)

Prof. Dr. Marcel Prokopczuk Alternative Investments 6

Real Assets
• Real assets involve direct ownership of an asset rather than an
indirect ownership through securitization
• Important aspect to consider: day-to-day managerial attention
• Natural resources are assets that have received little or no alteration,
such as mineral or energy resources
• Commodities are produced or extracted resources, e.g. oil, wheat or
copper and are homogeneous which facilitates (futures) trading
• Exposure to commodities can be obtained through futures contracts,
physical commodities, natural resource companies or exchange-
traded funds
Prof. Dr. Marcel Prokopczuk Alternative Investments 7
Real Assets (II)
• Real estate can be land and/or buildings
• Historically, land is possibly the oldest investment asset
• Land includes timberland and farmland
• Buildings can be commercial or residential
• Infrastructure investments include claims on the income of toll roads,
bridges, ports, airports
• Intellectual property includes patents, copyrights, royalties from
music and movies, etc.
• Although these are intangible assets, they are not financial
Prof. Dr. Marcel Prokopczuk Alternative Investments 8
Hedge Funds
• Most visible category of alternative investments
• A hedge fund is a privately organized investment vehicle which uses
its less regulated nature to generate investment opportunities
• There is a wide variety of hedge fund strategies
• Managed futures are included in this category

Prof. Dr. Marcel Prokopczuk Alternative Investments 9

Private Equity (and debt)
• Private equity (and debt) are not publicly traded and includes
• Venture capital, financing of start-ups
• Leveraged buyouts (LBOs), highly leveraged purchase of the equity of
a company
• Mezzanine debt, positions between senior secured debt and equity,
such as convertible debt
• Distressed debt, companies that have, or are near to, filing
bankruptcy
-> Private equity is covered in a separate module

Prof. Dr. Marcel Prokopczuk Alternative Investments 10

Structured Products
• Specifically designed instruments to create unique cash flow
characteristics
• Stocks and bonds are actually very simple structured products
• Collateralized Debt Obligations (CDO) are more complicated securities
• Credit derivatives are also popular structured products
-> Structured products are covered in a separate module

Prof. Dr. Marcel Prokopczuk Alternative Investments 11

Traditional vs Alternative Assets
• Note that the differentiation between traditional and alternative
assets is not always clear-cut
• Example 1: ETF shorting the S&P500
• Example 2: Real estate vs REITs
• Example 3: Complex structured products vs simple derivatives
• Moreover, institutional investors may expand their coverage over
time:
• Example 1: Corporate bonds in 1920
• Example 2: International equity in 1950
• Example 3: Commodities in 2000

Prof. Dr. Marcel Prokopczuk Alternative Investments 12

Return Characteristics of Alternative Assets
• How do alternative differ from traditional investments, i.e. long only
stocks and bonds?
• Diversification: low correlation (absolute return product)
• Illiquidity: Many (but not all) alternative investments are illiquid
• Inefficiency: Less informationally efficient
• Non-Normality: Skew, jumps, heavy-tails in return distribution

Prof. Dr. Marcel Prokopczuk Alternative Investments 13

More Aspects to Consider with Alternative
Investments
1. Regulatory factors
2. Structuring
3. Trading strategies
4. Compensation structures
5. Institutional factors
6. Information asymmetries
7. Incomplete markets
8. Innovation

Prof. Dr. Marcel Prokopczuk Alternative Investments 14

Five Goals of Alternative Investing
• Adding value through active management: active risk and return
• Achieving absolute and relative returns
• Absolute return standard: Remove systematic risk, benchmark is zero
• Relative return standard: Outperform market
• Pursuing arbitrage and return enhancement
• Return enhancer
• Return diversifier
• Risk reduction through diversification
• Avoiding Obsolescence

Prof. Dr. Marcel Prokopczuk Alternative Investments 15

Participants in Alternative Investments
• Buy side
• Sovereign wealth funds
• Mutual funds
• Foundations
• Sell side
• Large dealer banks
• Brokers
• Outside service providers
• Accountants and auditors
• Attorneys
• Regulators

Prof. Dr. Marcel Prokopczuk Alternative Investments 16

 II. Natural Resources and Land

Prof. Dr. Marcel Prokopczuk Alternative Investments 17

Natural Resources
• Natural resources are real assets that have received (almost) no
human alteration
• Examples of natural resources are oil, natural gas, coal, water, etc.
• Natural resources can be interpreted as a real option to produce
commodities – the owner has the option to wait

Prof. Dr. Marcel Prokopczuk Alternative Investments 18

Natural Resources as Real Option: Example
• Assume you have negotiated a deal with s country to exploit a small oil
field
• The terms of the contract specify that you must start operations either
immediately or in exactly one year
• If you do neither, you lose the right to exploit the oil field at all
• It will cost $5 million start the oil production, whether you open it now or
in one year
• If start immediately, you expect it to generate $600,000 in free cash flow
the first year
• Future cash flows are expected to grow at a rate of 2% per year
• The cost of capital for this investment is 12%
Prof. Dr. Marcel Prokopczuk Alternative Investments 19
Natural Resources as Real Option: Example (II)

Prof. Dr. Marcel Prokopczuk Alternative Investments 20

Natural Resources as Real Option: Example (III)
• If the oil field were to start operations today, its value would be:

$600,000
V = = $6 million
12% − 2%

• This would give an NPV of $1 million.

• Given the flexibility you have to delay opening for one year, what should
you be willing to pay?
• When should you start operations?

Prof. Dr. Marcel Prokopczuk Alternative Investments 21

Natural Resources as Real Option: Example (IV)
• The payoff if you delay is equivalent to the payoff of a one-year European
call option on oil field with a strike price of $5 million
• Assume:
• The risk-free interest rate is 5%
• The volatility is 40%.
• If you wait you have an opportunity cost of $600,000 (the free cash flow in
the first year)
• In terms of a financial option, the free cash flow is equivalent to a dividend
paid by a stock. The holder of a call option does not receive the dividend
until the option is exercised

Prof. Dr. Marcel Prokopczuk Alternative Investments 22

Natural Resources as Real Option: Example (V)
• Current value of the asset without the “dividends” that will be
missed: $0.6 million
S x = S − PV (Div) = $6 million − = $5.46 million
1.12
• The present value of the cost to start production in one year is:
$5 million
PV (K ) = = $4.76 million
1.05

• The current value of the call option to start oil production is:
C = S x N (d1 ) − PV (K )N (d 2 )
= ($5.46 million)  (0.706) − ($4.76 million)  (0.557)
= $1.20 million  T
x
ln[S / PV (K )] ln(5.46 / 4.76)
d = + = + 0.20 = 0.543
 T
1
2 0.40
Prof. Dr. Marcel Prokopczuk Alternative Investments d2 = d1 −  T = 0.543 − 0.40 = 0.143 23
Natural Resources as Real Option: Example (VI)
• The value today from waiting to invest in the oil field next year (and only opening
it if it is profitable to do so) is $1.20 million.
• This exceeds the NPV of $1 million from starting the oil production today. Thus,
you are better off waiting to invest, and the value of the contract is $1.20 million
• What is the advantage of waiting in this case?
• If you wait, you will learn more about future prices
• Because the investment in the oil field is not yet committed, you can cancel your
plans if the profits (oil price) decline. By starting production today, you give up
this option to “walk away.”
• Whether it is optimal to invest today or in one year will depend on the magnitude
of any lost profits from the first year, compared to the benefit of preserving your
right to change your decision.

Prof. Dr. Marcel Prokopczuk Alternative Investments 24

Natural Resources as Real Option: Example (VII)

Current Value of Operating Oil Field

Prof. Dr. Marcel Prokopczuk Alternative Investments 25
Natural Resources as Real Option: Example (VIII)
• When you have the option of deciding when to invest, it is usually optimal to invest
only when the NPV is substantially greater than zero, otherwise wait
• Our example was simplified: In reality natural resources are usually American
perpetual option -> numerical valuation methods needed
• Other factors affecting the decision to wait:
• Volatility: The option to wait is most valuable when there is a great deal of
uncertainty
• Dividends: Absent dividends, it is not optimal to exercise a call option early
• In the real option context, it is always better to wait unless there is a cost to doing so.
The greater the cost, the less attractive the option to delay becomes
Prof. Dr. Marcel Prokopczuk Alternative Investments 26
Example Revisited
• Consider the previous example but now assume
• The volatility is 25% not 40%
• The volatility remains 40%, but waiting would lead competitors
to expand and reduce future free cash flows by 10%
• How does the value of the oil resources change?
• Is it still optimal to wait?

Prof. Dr. Marcel Prokopczuk Alternative Investments 27

Land
• Undeveloped land has no value per se
• The value of such land must be attributed to the possibility that the
land can be developed to be useful
• Land banking is the practice of buying undeveloped land which might
be developed in the future
• The attraction/value of undeveloped land is based on the potential
value in development and the costs of development

Prof. Dr. Marcel Prokopczuk Alternative Investments 28

Land as Option
• Undeveloped land can be interpreted as an option (similar as for
natural resources)
• The strike price is the cost of developing
• Thus, the underlying asset is the spread between the value of the
developed land and the cost of development
• If there are multiple potential uses, we have can have a (complicated)
portfolio of options

Prof. Dr. Marcel Prokopczuk Alternative Investments 29

Land as Option: Example (I)
• For simplicity we will again assume just one period and a risk-free rate
of zero
• Consider a parcel of land which can be improved.
• The cost of construction and the value of the improved land depend
on the state of the economy
• If we have an expansion, the construction cost will be $100,000 and
the selling price is $160,000
• If we have a recession, the construction cost will be $80,000 and the
selling price is $70,000
• Comparable improved properties sell today for $100,000
Prof. Dr. Marcel Prokopczuk Alternative Investments 30
Land as Option: Example (II)
• We can use a Binomial tree for valuing the option
• First, we need to determine the risk-neutral probabilities for the state
of the economy

𝑉0 = 𝑞 ∙ 𝑉𝑈 + (1 − 𝑞) ∙ 𝑉𝐷

$100,000 = $160,000 ∙ 𝑞 + $70,000 ∙ 1 − 𝑞

• We get
𝑞 = 1/3

Prof. Dr. Marcel Prokopczuk Alternative Investments 31

Land as Option: Example (III)
• Now we can value the option to develop the land
• In case of an expansion, the profit will be $60,000
• If we enter a recession, the profit would be negative, so we will rather
not develop
• For simplification, we assume that development will not be profitable
for the foreseeable future

1 2
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑙𝑎𝑛𝑑 = $60,000 ∙ + $0 ∙ = $20,000
3 3

Prof. Dr. Marcel Prokopczuk Alternative Investments 32

Return of Investing in Land
• Analyzing the Return of land investing may suffer from survivorship
bias
• Undeveloped land has usually a very low return for many periods
• However, once it is developed, it exhibits a very high return
• But then, it is not undeveloped land anymore and potentially not
included in the database employed to estimate historical returns
• Example: assume undeveloped land has a return of 5%, once
developed 25%. 20% of land in a database is developed in a particular
year
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 = 0.2 ∙ 25% + 0.8 ∙ 5% = 9%
• But the average return based on the database is 5%
Prof. Dr. Marcel Prokopczuk Alternative Investments 33
Timberland
• Timberland (i.e. forests) have long been recognized as a long-term
investment
• Timberland involves substantial management which institutional
investors may not want to be involved with
• Timberland investment management organizations (TIMOs) provide
management services to timberland owners
• In contrast to farmland, timber as rather long rotation cycles (25-80
years, depending on type)
• But timber also offers substantial timing option

Prof. Dr. Marcel Prokopczuk Alternative Investments 34

Characteristics of Timber Investment
• Advantages:
• Low correlations with traditional asset
• Timing options
• Inflation hedge

• Disadvantages
• Tied to cyclical housing sector
• Long growth cycle makes it exposed to the risk of changes in technology and
preferences
• Risk due to natural disasters

Prof. Dr. Marcel Prokopczuk Alternative Investments 35

Farmland
• Farmland provides income that is derived from crops
• Thus, it is linked to commodity prices and may be more volatile
• Almost no timing option as with timberland
• Short cycles create the real option to change from one crop to
another
• Farming business is heavily affected by political decisions
• Subsidies
• Nature conservatory laws
• Trade wars

Prof. Dr. Marcel Prokopczuk Alternative Investments 36

Valuation and Volatility: Return Smoothing
• When investing in non publicly traded assets, return smoothing can
be a serious problem
• An asset may appear less risky (lower volatility) simply because true
values are unobservable
• This can happen unintentionally or intentionally

Prof. Dr. Marcel Prokopczuk Alternative Investments 37

Causes for Smoothing
• Intentional smoothing: Four primary ways of managing returns
1. Favorable mark: subjective appraisals
2. Selective appraisal: timing of appraisals
3. Model manipulation: changing input parameters
4. Market manipulation: trading to manage prices
• Since valuation of illiquid assets is often done by expert appraisal,
there is a natural tendency for smoothing (anchoring effect)
• In illiquid markets, we observe only infrequent price observations

Prof. Dr. Marcel Prokopczuk Alternative Investments 38

Stale Prices
• Stale prices are indications of value derived from data that no longer
represent current market conditions
• Assume 𝑟𝑡 is the true return of an asset in period t
• The true return is observed on a delayed basis by the appraiser
• Assume the appraiser uses a blend of the true return and the asset’s
previous return, i.e.

𝑟𝑡∗ = 𝛼𝑟𝑡 + (1 − 𝛼)𝑟𝑡−1

Prof. Dr. Marcel Prokopczuk Alternative Investments 39

 Stale Prices and Historic Mean Returns
• If we now estimate historic mean returns based on the stale returns, how
does it differ from the true mean?
• We have:

1
𝑟= (𝑟 + 𝑟2 + ⋯ + 𝑟𝑇 )
𝑇 1
and
∗ 1
𝑟 = 𝛼𝑟1 + 1 − 𝛼 𝑟0 + (𝛼𝑟2 + 1 − 𝛼 𝑟1 + ⋯ + (𝛼𝑟𝑇 +(1 − 𝛼)𝑟𝑇−1 )
𝑇

Prof. Dr. Marcel Prokopczuk Alternative Investments 40

Stale Prices and Historic Mean Returns (II)
∗
• Subtracting 𝑟 from 𝑟 we get
( 1 − 𝛼 (𝑟0 −𝑟𝑇 ))

• And thus we get the general relationship

∗
𝑟 = 𝑟 +( 1 − 𝛼 (𝑟0 −𝑟𝑇 ))

• The error in estimating the true mean is due to an overweighting of

period zero, and an underweighting of the final period T

Prof. Dr. Marcel Prokopczuk Alternative Investments 41

Stale Prices and Volatility
• Consider a smoothed return series that is formed by an equally
weighted average over N periods

1
𝑟𝑡∗ = (𝑟𝑡 + 𝑟𝑡−1 + ⋯ + 𝑟𝑡− 𝑁−1 )
𝑁

• If the return series is iid, one can show that the volatility of is given as

𝜎 𝑟𝑡
𝜎 𝑟𝑡∗ =
𝑁
Prof. Dr. Marcel Prokopczuk Alternative Investments 42
Historical Returns of Timberland

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 43

 III. Commodities

Prof. Dr. Marcel Prokopczuk Alternative Investments 44

Commodity Investments
• Energy: Crude oil, refined products, natural gas, electricity, coal
• Base metals: Copper, aluminium, zinc, lead, tin, nickel
• Precious metals: Gold, silver, platinum and palladium
• Agriculture: Soybeans, wheat, corn, coffee
• Livestock: Cattle, hogs, salmon
• Others: Emissions, freight, forest products

Prof. Dr. Marcel Prokopczuk Alternative Investments 45

Commodity Futures
• Investment into commodities could be made by buying the physical
commodity, e.g. oil
• However, institutional investors usually prefer to gain exposure via
futures contracts for the following reasons

1. Avoid storage and transportation costs

2. Avoid wasting convenience yield implicit in inventories
3. Avoid the need for (full) financing

Prof. Dr. Marcel Prokopczuk Alternative Investments 46

Hotelling’s Theory
• Hotelling’s theory states that prices of exhaustible comomdities, such
as energy or metals, should increase by the nominal interest rate, plus
a risk premium
• Ignoring storage costs, we can write

𝐸 𝑃𝑖,𝑇 = 𝑃𝑖,0 𝑒 𝑟𝑇

• Where r denotes the risk-adjusted rate of return for commodity i.

Prof. Dr. Marcel Prokopczuk Alternative Investments 47

Technological Innovation
• One may argue that Hotelling’s theory ignores technological
innovation
• If extraction of commodities become less costly, the prices of
commodities might decline in competitive markets
• The consequence is that prices might increase less than predicted by
Hotelling’s theory:

𝐸 𝑃𝑖,𝑇 ≤ 𝑃𝑖,0 𝑒 𝑟𝑇

Prof. Dr. Marcel Prokopczuk Alternative Investments 48

Investment through Commodity Companies
• Another way to (indirectly) invest into commodities is by buying
equity of commodity producing companies
• However, this is complicated by several things
• First, most companies engage in varies activities, thus it is difficult to
obtain pure exposure to one commodity
• Second, the company might hedge the commodity price risk which
makes the equity price less related to the commodity price
• Third, the equity price carries idiosyncratic risk

Prof. Dr. Marcel Prokopczuk Alternative Investments 49

Commodity-Linked Exchange-Traded Funds and Notes

• If the objective is to invest into a basket of commodities, and easy

way is through exchange-traded funds (ETF)
• The ETF can invest either in the physical commodity or commodity
futures
• Exchange Traded Notes (ETN) aka as CLN are similar, but do not offer
a direct claim on the underlying but are debt securities
• This means ETNs are exposed to credit risk of the issuer
• For some investors, who have investment restrictions, ETNs are a
good way to gain commodity exposure

Prof. Dr. Marcel Prokopczuk Alternative Investments 50

Total Return Swap

Prof. Dr. Marcel Prokopczuk Alternative Investments 51

Term Structure of Futures Prices

Prof. Dr. Marcel Prokopczuk Alternative Investments 52

Commodity Futures Pricing
• Commodity futures prices can be obtained by the cost-of carry
approach

𝐹𝑡 𝑇 = 𝑆𝑡 𝑒 (𝑟𝑓 +𝑠−𝑦)(𝑇−𝑡)

• where
𝑟𝑓 = risk-free rate
s = storage costs
𝑦 = convenience yield

Prof. Dr. Marcel Prokopczuk Alternative Investments 53

Futures Returns and Rolling
• The total return of a fully collateralized futures position is

𝑅𝑓𝑐𝑜𝑙𝑙 = 𝐶𝑜𝑙𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑌𝑖𝑒𝑙𝑑 + 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛

• The excess return may be broken into the change in the spot price
and the change in basis (Spot price – Futures price)

𝑅𝑓𝑐𝑜𝑙𝑙 = 𝑆𝑝𝑜𝑡 𝑅𝑒𝑡𝑢𝑟𝑛 + 𝑅𝑜𝑙𝑙 𝑌𝑖𝑒𝑙𝑑 + 𝐶𝑜𝑙𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑌𝑖𝑒𝑙𝑑

Prof. Dr. Marcel Prokopczuk Alternative Investments 54

Futures Returns and Rolling (II)
• Spot return: return of the underlying in the spot market
• Collateral yield: Interested earned on collateral, i.e. risk-free rate
• Roll yield: return due to changes in the basis
• The basis changes due (i) to passage of time and (ii) changes in the
costs of carry

Prof. Dr. Marcel Prokopczuk Alternative Investments 55

Interpretation of Roll Yield
• There are two ways to interpret the roll yield
• First, it can be viewed due to the transaction of switching from short-
term futures to longer term futures
• Second, one may use it to describe how the price “rolls up” (or down)
the term structure as settlement approaches and the basis changes
• The latter view may be considered economically more meaningful.
The switch of contract simply realizes the previously accrued gains
and losses

Prof. Dr. Marcel Prokopczuk Alternative Investments 56

Roll Returns and Total Returns
• Consider a commodity futures market is in backwardation

• Does that mean that returns will be positive?

Prof. Dr. Marcel Prokopczuk Alternative Investments 57

Roll Returns and Total Returns (II)
• Answer: NO!!

Prof. Dr. Marcel Prokopczuk Alternative Investments 58

Keynes Theory of Normal Backwardation
• Keynes (1930) postulated the Theory of Normal Backwardation
• Two market participants:
• Hedgers: companies that produce the commodity
• Speculators: financial investors
• By entering a futures position with the hedger, the speculator is
taking over the price risk
• Speculators are only willing to do so if they can expect to earn a risk
premium

Prof. Dr. Marcel Prokopczuk Alternative Investments 59

Normal Backwardation and Risk Premia
• Futures price can be decomposed in expected spot price and risk
premium
𝐹𝑡 𝑇 = 𝐸[𝑆𝑡 ] + 𝑅𝑃𝑡
• Following Keynes argument, 𝑅𝑃𝑡 is negative
• However, one might argue that there are hedgers on both side of the
market
• Moreover, we could have consumers and produces with different
time preferences (aka habitat)
• This can lead to various shapes of the term structure
Prof. Dr. Marcel Prokopczuk Alternative Investments 60
Humped Futures Curve

Prof. Dr. Marcel Prokopczuk Alternative Investments 61

Historical Performance of Commodities

Source: Gorton and Rouwenhorst (2006)

Prof. Dr. Marcel Prokopczuk Alternative Investments 62

Historical Performance of Commodities (II)
• Risk premiums for annualized monthly returns
• July 1959 – December 2004

Commodities Stocks Bonds

Average (%) 5.23 5.65 2.22
Standard Deviation (%) 12.10 14.85 8.47
t-Statistic 2.92 2.57 1.77
Sharpe ratio 0.43 0.38 0.26
Percent returns > 0 55 57 54

Source: Gorton and Rouwenhorst (2006)

Prof. Dr. Marcel Prokopczuk Alternative Investments 63

Commodities for Diversification
• Four reasons why commodities may provide diversification benefits
• Commodity prices are determined by different economic
fundamentals than stocks and bonds which prices are determined by
future cash flows and discount rates
• Commodity prices should be positively correlated with inflation
• Commodity prices behave differently over the business cycle as they
are more driven by current conditions than future expectations
• Commodity prices are major inputs for corporations

Prof. Dr. Marcel Prokopczuk Alternative Investments 64

Diversification and Inflation Hedging
• Correlations of commodity returns with stocks, bonds, and
inflation, July 1959 – December 2004
Holding Period Stocks Bonds Inflation
Monthly 0.05 -0.14* 0.01
Quarterly -0.06 -0.27* 0.14
One year -0.10 -0.30* 0.29*
Five years -0.42* -0.25* 0.45*

Source: Gorton and Rouwenhorst (2006)

Prof. Dr. Marcel Prokopczuk Alternative Investments 65

Portfolio Diversification

Source: Erb and Harvey (2006)

Prof. Dr. Marcel Prokopczuk Alternative Investments 66

Returns over the Business Cycle

Source: Gorton and Rouwenhorst (2006)

Prof. Dr. Marcel Prokopczuk Alternative Investments 67

Commodity Futures vs Commodity Stocks

Source: Gorton and Rouwenhorst (2006)

Prof. Dr. Marcel Prokopczuk Alternative Investments 68
Commodity Indices
• As in other markets, indices provide some useful services
• Indices can be used as benchmarks or as passive investment strategy
• In contrast to, e.g. equity markets, construction of commodity indices
is complicated by
• The need to define and implement a roll strategy
• The selection of the commodities
• The weighting of the commodities
• The weighting can be based on
• Production (e.g. S&P GSCI Index)
• Liquidity (e.g. Bloomberg Commodity Index)
• Tiers (Thomson Reuters/CRB Index)
Prof. Dr. Marcel Prokopczuk Alternative Investments 69
S&P GSCI Index

Prof. Dr. Marcel Prokopczuk Alternative Investments 70

Commodity Risk Attributes

• Commodity long positions are considered to be beneficial in terms of

the risks due to major events, such as international tension of
financial turmoil
1. Global crises often lead to increasing commodity prices due to
disrupted supplies
2. Price increases due to events tend to be large than decreases
3. Commodity shocks are mostly uncorrelated to each other and
therefore diversifiable
4. Shocks to commodity markets tend to be uncorrelated to financial
shocks

Prof. Dr. Marcel Prokopczuk Alternative Investments 71

Financialization and the Masters Hypothesis
• The aforementioned aspects may have changed recently due to the
Commodity Futures Modernization Act of 2000 (CFMA)
• This led to a an inflow of many financial passive, long-only investors
• Michael Masters, a leading hedge fund manager, testified multiple
times at the U.S. Congress
• He argued that the huge buy-side demand from index investors
created a bubble in commodity prices
• This is known as “Masters Hypothesis”

Prof. Dr. Marcel Prokopczuk Alternative Investments 72

 IV. Real Estate

Prof. Dr. Marcel Prokopczuk Alternative Investments 73

Categories of Real Estate
• Equity vs Debt
• Domestic vs International
• Residential vs Commercial
• Private vs Public
• Primary, Secondary & Tertiary Markets

Prof. Dr. Marcel Prokopczuk Alternative Investments 74

Advantage and Disadvantages of Real Estate
• Advantages:
1. Potential to offer absolute returns
2. Potential to hedge against unexpected inflation
3. Potential to provide diversification with stocks and bonds
4. Potential to provide cash inflows
5. Potential to provide income tax advantages

• Disadvantages:
1. Heterogeneity
2. Lumpiness
3. Illiquidity

Prof. Dr. Marcel Prokopczuk Alternative Investments 75

Real Estate Styles
• In 2003, the National Council of Real Estate Investment Fiduciaries
(NCREIF) defined three styles of real estate investing
1. Core Real Estate Style: High income, low volatility, most liquid, most
developed, least leverage
2. Value-Added Real Estate Style: Less current income, more appreciation in
value, moderate volatility
3. Opportunistic Real Estate Style: Mostly appreciation, substantial volatility,
potentially high leverage

Prof. Dr. Marcel Prokopczuk Alternative Investments 76

 Styles Overview
The Underlying Eight Attributes of the Three Real Estate Styles
Core Attributes Value-Added Attributes Opportunistic Attributes
Property type Major property types only: office, Major property types plus specialty retail, Nontraditional property types, including
apartments, retail, and industrial hospitality, senior/assisted-care housing, speculative development for sale or rent
storage, low-income housing and undeveloped land

Life-cycle phase Fully operating Operating and leasing Development and newly constructed
Occupancy High occupancy Moderate to well-leased and/or Low economic occupancy
substantially preleased development
Rollover concentration Tend to be held for a long period of time, Moderate rollover concentration—a High rollover concentration risk—most of
forming the central component of the higher percentage of the assets are held the assets are held for appreciation and
real estate portfolio, which is geared for a short- to intermediate-term sale and resale
toward generating income rather than rollover into new assets
sales appreciation
Near-term rollover Low total near-term rollover Moderate total near-term rollover High total near-term rollover
Leverage Low leverage Moderate leverage High leverage
Market recognition Well-recognized institutional properties Institutional and emerging real estate Secondary and tertiary markets and
and locations markets international real estate
Investment structure/control Investment structures often have Investment structures often have Investment structures often have
substantial direct control moderate control, but with security or a minimal control, usually in a limited
preferred liquidation position partnership vehicle and with unsecured
positions
Source: CAIA Level I learning material
Prof. Dr. Marcel Prokopczuk Alternative Investments 77
Residential Mortgages
• Fixed-rate mortgages are loans with constant repayment rates over a
fixed period, i.e. an annuity
• This can be calculated as
𝑖
𝑀𝑃 = 𝑀𝐵 ∙ ( −𝑛
)
1− 1+𝑖
• where
• MP = Constant monthly payment
• MB = Amount borrowed
• i = monthly interest rate
• n = number of months

Prof. Dr. Marcel Prokopczuk Alternative Investments 78

Residential Mortgages: Example
• Assume that a borrower takes out a $100,000, 25-year mortgage (300
months), at a 6% annual nominal interest rate (a monthly interest rate
of 6%/12, or 0.5%). What is the mortgage's monthly payment?

0.005
𝑀𝑃 = $100,000 ∙ −300
= $644.30
1 − 1.005

Prof. Dr. Marcel Prokopczuk Alternative Investments 79

Residential Mortgages: Example (II)
Beginning-of- End-of-Month
Month Mortgage Mortgage Principal Mortgage
Month Balance Payment Interest Payment Payment Balance
1 $100,000.00 $644.30 $500.00 $144.30 $99,855.70
2 $99,855.70 $644.30 $499.28 $145.02 $99,710.68
3 $99,710.68 $644.30 $498.55 $145.75 $99,564.93
⋮ ⋮ ⋮ ⋮ ⋮ ⋮
59 $90,318.56 $644.30 $451.59 $192.71 $90,125.86
60 $90,125.86 $644.30 $450.63 $193.67 $89,932.18
61 $89,932.18 $644.30 $449.66 $194.64 $89,737.55
⋮ ⋮ ⋮ ⋮ ⋮ ⋮
299 $1,279.96 $644.30 $6.40 $637.90 $642.06
300 $642.06 $644.30 $3.21 $641.09 $1 (rounded)
Source: CAIA Level I learning material
Prof. Dr. Marcel Prokopczuk Alternative Investments
Prepayments
• In many mortgage contacts, the borrower can make unscheduled
principal payments
• These are payments on-top of the regular payments and reduce the
principal
• This is essentially an embedded option for the borrower
• Unscheduled payments thus cause a wealth transfer between
borrower and lender
• The lender will anticipate this and will demand a higher interest rate
when the loan is agreed

Prof. Dr. Marcel Prokopczuk Alternative Investments 81

Interest-Only Mortgages
• Some fixed-rate mortgages are interest-only mortgages, which means
that the principal is not repaid
• Often, there is a mix, i.e. for some initial years interest-only, then
fixed rate loan
• The most popular combinations are 10/20 and 15/15

Prof. Dr. Marcel Prokopczuk Alternative Investments 82

Variable-Rate Mortgages
• In a variable-rate mortgage, the interest rate is indexed to some
market rate
• Example
Beginning of
Year Index Rate + Margin Rate = Interest Rate Year Monthly End of Year
1 7.0% $100,000.00 $706.78 $98,470.30

2 8.5% 1.5% 10.0% $98,470.30 $903.36 $97,430.75

3 10.0% 1.5% 11.5% $97,430.75 $1,006.05 $96,515.25

4 8.0% 1.5% 9.5% $96,515.25 $872.94 $95,150.13

• The might also be an interest rate cap

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 83

Residential Mortgages and Default Risk
• Uninsured mortgages with borrowers of relatively high credit risk are
known as subprime mortgages
• Ratio analysis can be used to measure the credit risk
• Debt-to-income ratio
• Front-end ratio
• Loan-to-value ratio (LTV)
• LTV of up to 80% are generally viewed as being well collateralized

Prof. Dr. Marcel Prokopczuk Alternative Investments 84

Commercial Mortgages
• Commercial mortgage loans a re backed by commercial real estate,
e.g. hotels, offices, retail and industrial properties, etc.
• Less standardized than residential mortgage loans, often shorter
terms, default risk often more substantial
• Covenants are promises made by the borrower and can trigger
default
• Recourse is the set of rights or means that an entity such as a lender
has in order to protect its investment
• In addition to the LTV, the interest coverage ratio, i.e. the net
operating income divided by the loan’s interest payment is important
Prof. Dr. Marcel Prokopczuk Alternative Investments 85
Mortgage-Backed Securities Market
• Mortgage-backed securities (MBS) are a type of asset-backed
security that is secured by a mortgage or pool of mortgages
• A pass-through MBS is simply a pool of mortgages with pro-rata
rights to the cash-flows
• Collateralized mortgage obligations (CMO) repackage the cash-flows
to create different types of securities, called tranches

Prof. Dr. Marcel Prokopczuk Alternative Investments 86

Residential Mortgage Prepayment Options
• The right of the borrower to make unscheduled principal payments
can be interpreted as a call option
• The lender is short the option on the value od the loan (as in a
callable bond)
• Borrowers will exercise this option if interest rates decline by
refinancing themselves elsewhere
• However, there might be also idiosyncratic reasons for prepayments
• Prepayment risk is the most important aspect, if the LTVs are
reasonable

Prof. Dr. Marcel Prokopczuk Alternative Investments 87

Measuring Unscheduled Prepayment Rates
• The annualized percentage of a mortgage's PSA Benchmark Pattern

remaining principal value that is prepaid in Month CPR

a particular month is known as 1 0.2%
the conditional prepayment rate (CPR) 2 0.4%
• The Public Securities Association (PSA) 3 0.6%
established the PSA benchmark, a ⋮ ⋮
benchmark of prepayment speed that is 29 5.8%
based on the CPR and that has become the 30 6.0%

standard approach used by market 31 6.0%

participants 32 6.0%
⋮ ⋮

Prof. Dr. Marcel Prokopczuk Alternative Investments 88

PSA Benchmark: Examples
• Other prepayment speeds are then expressed relative to the PSA,
which is 100%
Actual Prepayment Month PSA Benchmark PSA Prepayment Rate
1.00% 2 0.40% 250.0%
1.00% 7 1.40% 71.4%
3.00% 4 0.80% 375.0%
2.00% 15 3.00% 66.7%
1.00% 19 3.80% 26.3%
6.00% 40 6.00% 100.0%
2.00% 20 4.00% 50.0%

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 89

Real Estate Investment Trusts (REITs)
• A Real Estate Investment Trust (REIT) is similar to a normal company,
but this company mostly owns real estate
• The overall idea is similar mutual funds
• Since REITs are often listed, they are relatively liquid
• Once can distinguish Equity REITs and Mortgage REITs
• In the US, REITs must derive 75% of their income from real estate
activities and must pay out 90% or more of their taxable income in
the form of dividends

Prof. Dr. Marcel Prokopczuk Alternative Investments 90

Historical Returns of Mortgage REITs

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 91

Real Estate Development
• A real estate development investment is an equity-type investment
• It usually entails the following stages
1. Acquisition of land
2. Estimating potential and profitability of development
3. Developing building program and design
4. Procuring the necessary public approvals and permits
5. Raising the necessary financing
6. Building the structure
7. Leasing, managing and perhaps selling

Prof. Dr. Marcel Prokopczuk Alternative Investments 92

Real Estate Development as Real Options
• Development is one of the most entrepreneurial and also riskiest
activities in the context of real estate investments
• A new asset is created
• During the process, a high degree of uncertainty prevails
• Real estate development projects can be interpreted as real options
• Each stage may be viewed as individual call
• The final sell is a put

Prof. Dr. Marcel Prokopczuk Alternative Investments 93

Example
• Consider the decision to build a hotel next to a stadium
• The sports league will announce whether to award a franchise in one year
• If yes, the hotel is needed in three years
• Assume the following costs

First Year Purchase of rights, land, plans, and permits $10,000,000

Second Year Construction of building shell $20,000,000
Third Year Construction of building interior and furnishings $20,000,000
Total $50,000,000

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 94
Example (II)
• If the franchise is successful, the hotel will be worth $80 million
• If not, it will be only worth $20 million
• For simplicity, we assume the risk-free rate is zero
• If the chances are 50/50, the expected value is $50 million
• Since the costs are also $50 million, the NPV will only be positive, if
the probability of success is larger than 50%
• But the NPV analysis is flawed. It assumes that there is no managerial
flexibility
• Rel options analysis takes this into account
Prof. Dr. Marcel Prokopczuk Alternative Investments 95
Example (II)
• In the first year, we pay $10 million to acquire the “option” to build
the hotel
• Then, we can continue the project or abandon, depending on the
decision of the sports league
• If successful, we invest another $40 million to realize the payoff of
$80 million
• If not, we abandon and have lost only $10 million
• Thus, the project is already profitable, if the chances of the franchise
being granted are larger than 25%

Prof. Dr. Marcel Prokopczuk Alternative Investments 96

Decision Trees for Real Option Analysis
• The hotel example was very simple. In reality, projects may be more
complex
• Often, projects can be delayed, expanded, reduced or otherwise altered
• A decision tree is a useful tool for the analysis
• In the decision tree, we have decision nodes (A, C, D) and information
nodes (B)
• As known from the Binomial tree, we can solve the decision problem buy
backward induction

Prof. Dr. Marcel Prokopczuk Alternative Investments 97

Decision Trees for Real Option Analysis (II)

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 98

Decision Trees for Real Option Analysis (III)

Decision at node C and D

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 99

Decision Trees for Real Option Analysis (IV)

Decision at node B Decision at node A

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 100

Commercial Real Estate Valuation
• There are several valuation approaches for commercial real estate
• The comparable sale price approach values through transaction
values of similar estates
• This is, together with the income approach, one of the main methods
in real estate valuation
• Advantage: Based on real transactions
• Disadvantage: Still substantial subjectivity, problematic if no similar
estates were transacted

Prof. Dr. Marcel Prokopczuk Alternative Investments 101

Commercial Real Estate Valuation (II)
• Profit and cost approaches
• The profit approach looks at the profitability of the business using the
real estate rather than at the property itself
• Should only be used if the value of property is mainly based on the
specific business (no other use)
• The cost approach considers what t would cost to build a similar
property
• Especially useful for new constructions

Prof. Dr. Marcel Prokopczuk Alternative Investments 102

Commercial Real Estate Valuation (III)
• Valuation based on the capitalization (cap) rate is also popular
• The cap rate is the net operating income of the investment, divided
by the total value, such as purchase price or appraised value
𝑁𝑂𝐼
𝐶𝑎𝑝𝑅𝑎𝑡𝑒 =
𝑉𝑎𝑙𝑢𝑒
• The cap rate can be interpreted as an estimate of expected/required
returns
• If we observe cap rates in the market, we can use these to determine
the value of the property

Prof. Dr. Marcel Prokopczuk Alternative Investments 103

Commercial Real Estate Valuation (IV)
• The income approach uses the discounted cash flow method (DCF)
• This is the second major valuation approach
• Net operating income are projected then discounted using an
estimate of an appropriate discount rate
• Especially useful for income generating property, but requires a good
estimate of the NOI and discount rates

Prof. Dr. Marcel Prokopczuk Alternative Investments 104

Commercial Real Estate Valuation (IV)
• Repeat-Sales and Hedonic valuation approaches are possibly the
most systematic and quantitatively sophisticated methods
• Both require large data sets
• Repeat-Sales valuation looks at the price changes of the same
property, i.e. one requires at least two transactions
• Hedonic valuation uses regression methods to estimate the value
based on specific attributes

Prof. Dr. Marcel Prokopczuk Alternative Investments 105

Appraisal vs Transaction-Based Valuation
• Appraisal methods have two main advantages
1. They do not require large data sets
2. Valuation can be done as often as desired
• Disadvantages include
1. Subjective and backward looking
2. Appraisals based on indices might suffer from stale index values
3. Appraisal indices are smoothed compared to actual changes, thus
volatility is underestimated
4. Quality of appraisal critically depend on the availability of comparable
properties

Prof. Dr. Marcel Prokopczuk Alternative Investments 106

NCREIF Property Index
• NCREIF maintains a massive data set and uses those data to publish a
major real estate index the NCREIF Property Index (NPI)
• https://www.ncreif.org/data-products/property/
• NPI is a quarterly index
• However, appraisal of properties is often just done annually, or even
less often
• NCREIF has begun producing also a Transaction Based Index (TBI)

Prof. Dr. Marcel Prokopczuk Alternative Investments 107

Details of the Income Approach to Real Estate
Valuation
• Real estate generating regular income, can be valued using well-
known DCF methods

𝐸[𝐶𝐹1 ] 𝐸[𝐶𝐹2 ] 𝐸[𝐶𝐹𝑇 ] 𝑁𝑆𝑃

𝑉= + 2
+ ⋯+ 𝑇
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑇

• where 𝑁𝑆𝑃 are the net sale proceeds, i.e. the selling price minus
selling expenses at T

Prof. Dr. Marcel Prokopczuk Alternative Investments 108

Details of the Income Approach to Real Estate
Valuation (II)
• In case of real estate, the cash-flows are the net operating income
(NOI), i.e. the rental income minus all expenses maintaining and
operating the property

𝐸[𝑁𝑂𝐼1 ] 𝐸[𝑁𝑂𝐼2 ] 𝐸[𝑁𝑂𝐼𝑇 ] 𝐸[𝑁𝑆𝑃]

𝑉= + 2
+ ⋯+ 𝑇
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑇
𝑇
𝐸[𝑁𝑂𝐼𝑡 ] 𝐸[𝑁𝑆𝑃]
=෍ 𝑡
+
(1 + 𝑟) (1 + 𝑟)𝑇
𝑡=1

Prof. Dr. Marcel Prokopczuk Alternative Investments 109

Discount Rate
• We also need the discount rate
• The discount rate is usually assume to have three components, the
risk-free rate, a liquidity premium, and a risk premium, i.e.

𝑟 = (1 + 𝑟𝑓 ) 1 + 𝐸 𝑟𝑙 1 + 𝐸 𝑟𝑝 −1

𝑟 ≈ 𝑟𝑓 + 𝐸 𝑟𝑙 + 𝐸[𝑟𝑝 ]

Prof. Dr. Marcel Prokopczuk Alternative Investments 110

 Income Approach: Example
• Consider the following example of NOI
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Potential gross income $300,000 $312,000 $324,480 $337,459 $350,958 $364,996 $379,596
Vacancy and collection losses −$30,000 −$31,200 −$32,448 −$33,746 −$35,096 −$36,500 −$37,960
Effective gross income $270,000 $280,800 $292,032 $303,713 $315,862 $328,496 $341,636
Operating expenses −$117,000 −$121,680 −$126,547 −$131,609 −$136,873 −$142,348 −$148,042
Net operating income $153,000 $159,120 $165,485 $172,104 $178,989 $186,148 $193,594

• The NSP is estimated to be $1,840,000 after year 7.

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 111

Income Approach: Example (II)
• Assume a US Treasury note currently yields 5.8%, the liquidity
premium is 1%, and the risk premium 2.2%
• We get

$153,000 $159,120 $193,594 $1,840,000

𝑉= + 2
+ ⋯+ 7
+
(1.09) (1.09) (1.09) (1.09)7

= $1,863,772

• This was of course a very simplified example

Prof. Dr. Marcel Prokopczuk Alternative Investments 112
Taxes
• The above example ignored income taxes
• There are two ways to incorporate taxes in the income valuation
• The pre-tax discounting approach considers the after-tax cash-flows
in the numerator
• The after-tax discounting approach uses an after-tax discount rate in
the denominator

Prof. Dr. Marcel Prokopczuk Alternative Investments 113

Alternative Real Estate Investment Vehicles
• Private equity real estate funds are privately organized funds
• Similar to private equity, but with a focus on real estate
• Useful for smaller institutional investor, to get access to larger
projects
• However, there is no direct control, and no clear exit route
• Commingled real estate funds (CREFs) are a type of private equity
real estate fund
• Similar to mutual funds, but less regulated
• Investor may receive a (tradable) ownership certificate
Prof. Dr. Marcel Prokopczuk Alternative Investments 114
Alternative Real Estate Investment Vehicles (II)
• Syndications are private equity real estate funds formed by a group of
investors
• Most real estate syndications are structured as limited partnerships,
with the syndicator performing as general partner and the investors
performing as limited partners
• Real estate joint ventures are private equity real estate funds that
consist of the combination of two or more parties, e.g. a financial
investor (without expertise) and a developer (without sufficient
financing)

Prof. Dr. Marcel Prokopczuk Alternative Investments 115

Alternative Real Estate Investment Vehicles (III)
• Open-end real estate mutual funds are public investments that offer
a non-exchange-traded means of obtaining access to the private real
estate market
• Since they are non-exchange-traded, liquidity can be limited and they
might suffer from stale pricing
• Exchange-traded funds (ETFs) represent a tradable investment
vehicle that tracks a particular index
• Very liquid, low trading costs, but no active management

Prof. Dr. Marcel Prokopczuk Alternative Investments 116

Alternative Real Estate Investment Vehicles (IV)
• A closed-end real estate mutual fund is an investment pool that has
real estate as its underlying asset and a relatively fixed number of
outstanding shares
• Unlike for open-end funds, there is no need to maintain liquidity in
order to redeem shares.
• It is also easier to operate with leverage
• Finally, Equity Real Estate Investment Trust (REIT) is a popular way of
investing
• REITs are usually publicly traded and very liquid, thus also available
for smaller investors
Prof. Dr. Marcel Prokopczuk Alternative Investments 117
Historical Risks and Returns of Equity REITs

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 118

 V. Hedge Funds

Prof. Dr. Marcel Prokopczuk Alternative Investments 119

What is a Hedge Fund?
• The first hedge fund was established by Alfred W. Jones in 1949
• The fund invested both long and short to limit systematic market risk
and focus on stock selection
• These days, the term hedge fund is used more broad, also including
funds that do not necessarily hold hedge positions
• Primary elements of a hedge fund (opposed to a mutual fund):
1. Privately organized
2. Performance-based fees for the managers
3. Can invest in non-standard assets, establish short positions, apply leverage

Prof. Dr. Marcel Prokopczuk Alternative Investments 120

Flexibilities of a Hedge Fund
• Investments in nonpublic, unlisted securities
• Use of leverage
• Use of derivatives securities
• Take short positions
• Invest in structured products
• More actively managed with more complex strategies

Prof. Dr. Marcel Prokopczuk Alternative Investments 121

Hedge funds vs Mutual Funds

Mutual Funds Hedge Funds

Manager registration Required Required
Offering method (documentation) Prescribed, detailed Flexible, voluntary
Disclosure requirements Prescribed, detailed Flexible, voluntary
Investment strategies available Restricted Unrestricted
Concentration limits Restricted Unrestricted
Use of leverage Restricted Unrestricted
Use of derivatives Restricted Unrestricted
Allowable investors Unrestricted (anyone) Restricted (accredited only)

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 122

Hedge Fund Fees
• A typical hedge fund arrangement has two components, a
management fee and a performance (incentive) fee
• The management fee is calculated as percentage (e.g. 2%) of the net
asset value (NAV)
• The performance fee is calculated as percentage (e.g. 20%) of the
profits

Annual Fee = Management Fee + max[0 , Performance Fee x (Return

above HWM – Management Fee – Hurdle Rate]

Prof. Dr. Marcel Prokopczuk Alternative Investments 123

High-water Mark (HWM) and Hurdle Rate
• The high-water mark is the highest past NAV that has been used to
calculate performance fees
• This is important, because otherwise performance fee might be paid
for increases after losses
• The hurdle rate is a minimum return that must be earned before
performance fee is paid

Prof. Dr. Marcel Prokopczuk Alternative Investments 124

 Example
Year Gross Hurdle Manage- Incentive Incentive Total Net Beginning Ending Ending
Return Rate ment Fee (% of Fee (% of Fee Return NAV NAV HWM
Fee (%) Profits) Assets)

Year 1 5.00% 3.00% 2.00 20.00 0.00 2.00% 3.00% $100.0 $103.0 $103.0
Year 2 5.00% 3.00% 2.00 20.00 0.00 2.00% 3.00% $103.0 $106.1 $106.1
Year 3 20.00% 3.00% 2.00 20.00 3.00 5.00% 15.00% $106.1 $122.0 $122.0
Year 4 −10.00% 3.00% 2.00 20.00 0.00 2.00% −12.00% $122.0 $107.4 $122.0
Year 5 15.60% 3.00% 2.00 20.00 0.00 2.00% 13.60% $107.4 $122.0 $122.0
Year 6 8.00% 3.00% 2.00 20.00 0.60 2.60% 5.40% $122.0 $128.6 $128.6

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 125

Problems of Performance Fees
• The performance fee can be viewed as call option
• Volatility increases the option’s value, managers might take excessive
risk
• This is why they are not allowed fir mutual funds
• One way to mitigate the agency problem is through managerial co-
investing
• The managers agrees to invest their own money
• However, this may lead to excessive conservatism, because the
manager might be poorly diversified

Prof. Dr. Marcel Prokopczuk Alternative Investments 126

Hedge Fund Fees and Managerial Behavior
• Researchers have studied the behavior of hedge fund managers
• Hodder and Jackwerth (2007) document the so-called lock-in effect,
i.e. managers take fewer risks after high returns
• They take, however, large risks, after negative returns
• Agarwal, Daniel and Naik (2009) show that managers tend to
massaging their reported returns, in order to align with the incentive
structure
• Kazemi and Li (2008) find that managers tend to increase volatility if
i. The incentive option is at the money
ii. The fund has spent significant time below the HWM
iii. The asset of the funds are liquid enough to do so
Prof. Dr. Marcel Prokopczuk Alternative Investments 127
Hedge Fund Classification
• The trading strategies of hedge funds can be very different
• The is no unique way to classify hedge funds
• CAIA uses the following classification
1. Macro and Managed Futures Funds
2. Event-Driven Hedge Funds
3. Relative Value Hedge Funds
4. Equity Hedge Funds
5. Funds of Hedge Funds

Prof. Dr. Marcel Prokopczuk Alternative Investments 128

Hedge Fund Indices
• Since hedge fund styles and skills in an index can be problematic
• Still, hedge fund indices are calculated to serve as proxies for the
entire asset class and to provide some benchmark
• Other issues include
• Incorporation of fees not easy
• Asset weighted vs equally weighted
• Self-reporting bias
• Survivorship bias
• Backfill bias
• Liquidation bias
• Investability

Prof. Dr. Marcel Prokopczuk Alternative Investments 129

Macro and Managed Futures Strategies
• Macro and managed futures funds focus on the big picture
• They try to benefit from anticipating price level movements in major
sectors or to take advantage of potential inefficiencies at sector and
country levels
• Based mostly on futures, forward, and swaps
• Thus, quite liquid a huge capacity
• Can be based on discretionary (humans) or systematic (machines)
trading
• Can be based on technical or fundamental analysis

Prof. Dr. Marcel Prokopczuk Alternative Investments 130

Global Macro
• Global marco funds can have various focuses
• Exchange rates
• Sovereign bonds
• Economic policy
• Thematic investing
• Success requires good understanding and forecasting at the macro level
• Main risk factors
• Market risk
• Event risk
• Leverage

Prof. Dr. Marcel Prokopczuk Alternative Investments 131

Managed Futures
• Active trading if futures and forward contracts on commodities,
financial assets, and exchange rates
• Very liquid, low margins, little credit risk
• More often based on technical analysis than fundamentals
• Three ways to access managed futures
• Public commodity pools
• Private commodity pools
• Individually managed accounts

Prof. Dr. Marcel Prokopczuk Alternative Investments 132

Systematic Trading
• Systematic (technical) trading refers to automation of the investment
process based on some systematic trading rule/quantitative model
• Usually derived via backtesting, i.e. analysis of historical data
• Data mining is a serious problem
• Often, past performance of a strategy does not translate into future
performance
• Transaction costs and slippage must be conisdered

Prof. Dr. Marcel Prokopczuk Alternative Investments 133

Evaluating a Systematic Trading System
• What is the trading system and how was it developed?
• Broadly understand the trading approach
• Avoid overfitting
• Why does the trading system work?
• From where does the money come from
• Under which conditions does it work
• How is the trading system implemented?
• Data sources
• Processes and protocols

Prof. Dr. Marcel Prokopczuk Alternative Investments 134

Validation of Systematic Trading Rules
• Once a trading strategy has been developed it should be tested for
robustness, i.e. with subsets of data, other data, etc.
• Ideally, these are out-of-sample data
• Especially for technical rules, it is important to know how many
strategies were tested in the first place
• Markets evolve over time, thus even if a strategy truly worked in the
past, in may not work in the future (degradation)

Prof. Dr. Marcel Prokopczuk Alternative Investments 135

Basic Systematic Strategies
• Systematic trading strategies are generally categorized into three
groups
• Trend-following
• Non-trend-following
• Relative value

Prof. Dr. Marcel Prokopczuk Alternative Investments 136

Simple Moving Averages
• The most basic trend-following strategy is based on moving average

1
𝑆𝑀𝐴𝑡 𝑛 = 𝑝𝑡−1 + 𝑝𝑡−2 + ⋯ + 𝑝𝑡−𝑛
𝑛
• Signals:
• Enter long if 𝑝𝑡 > 𝑆𝑀𝐴𝑡 𝑛
• Enter short if 𝑝𝑡 < 𝑆𝑀𝐴𝑡 𝑛
• Variations
• Observation frequency, estimation window (i.e. n), exceedance barrier,
weighting by e.g. EWMA, combination of two signals

Prof. Dr. Marcel Prokopczuk Alternative Investments 137

Example

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 138
Non-Trend-Following Strategies
• Non-trend-following strategies try to identify patterns other than
trends
• One popular example is the relative strength index

100
𝑅𝑆𝐼 = 100 −
𝑈
1+
𝐷
• U = average of all positive price changes over a certain period
• D = average of all negative (absolute) price changes over a certain
period
Prof. Dr. Marcel Prokopczuk Alternative Investments 139
Example

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 140

Relative Value Strategies
• Relative value strategies are based on two theoretically related
securities, such as natural gas and crude oil

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 141

Dimensions of Managed Futures Strategies

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 142

Systematic Futures Portfolio Construction
• The typical futures trading system is composed of the following four
core decisions:
• Entry: When to enter a position
• Position sizing: How large a position to take on
• Exit: When to get out of a position
• Market allocation: How much risk or capital to allocate to different
sectors and markets

Prof. Dr. Marcel Prokopczuk Alternative Investments 143

Benefits of Managed Futures for Investors
1. Diversification
2. Performance
3. Access to multiple markets
4. Transparency
5. Liquidity
6. Size
7. No withholding taxes
8. Little FX risk

Prof. Dr. Marcel Prokopczuk Alternative Investments 144

Risks of Managed Futures
• Transparency of trading system
• Model risk
• Capacity risk
• Liquidity risk
• Regulatory risk
• Lack of trend risk

Prof. Dr. Marcel Prokopczuk Alternative Investments 145

Event-Driven Hedge Funds
• Event driven strategies focus on specific corporate events
• The four major types we will discuss are
• Activist funds
• Merger arbitrage funds
• Distressed securities funds
• Multistrategy event-driven funds

Prof. Dr. Marcel Prokopczuk Alternative Investments 146

Activist Investing
• The activist investment strategy involves efforts by shareholders to
use their rights, such as voting power or the threat of such power, to
influence corporate governance to their financial benefit as
shareholders
• It involves
• identification of corporations whose management is not maximizing
shareholder wealth
• establishment of investment positions that can benefit from particular
changes in corporate governance, such as replacement of existing
management
• execution of the corporate governance changes that are perceived to benefit
the investment positions that have been established.

Prof. Dr. Marcel Prokopczuk Alternative Investments 147

Five Dimensions of Shareholder Activists
• Financial versus social activists: Efforts by shareholder activists can have
social objectives or financial objectives
• Activists versus pacifists: Activists oppose current management and seek
major
• Initiators versus followers: Some shareholders initiate activism, whereas
others actively follow the activists changes in a firm’s leadership or
decision-making
• Friendly versus hostile activists: Activism is executed with different degrees
of confrontation with management
• Active activists versus passive activists: This dimension refers to the motive
for investing

Prof. Dr. Marcel Prokopczuk Alternative Investments 148

Merger Arbitrage
• Merger arbitrage attempts to benefit from merger activity with
minimal risk and is perhaps the best-known event-driven strategy
• Traditional merger arbitrage generally uses leverage to buy the stock
of the firm that is to be acquired and to sell short the stock of the firm
that is the a
• This traditional merger arbitrage strategy seeks to capture the price
spread between the ratio-adjusted spreads of the current market
prices of the merger partners and the spreads upon the successful
completion of the merger acquirer
• Being long the target and short the bidder exposes the arbitrageur to
risk that the merger will fail
Prof. Dr. Marcel Prokopczuk Alternative Investments 149
Merger Arbitrage going Right: Microsoft & Visio

Prof. Dr. Marcel Prokopczuk Alternative Investments 150

Merger Arbitrage going Wrong: GE & Honeywell

Prof. Dr. Marcel Prokopczuk Alternative Investments 151

Historical Returns of Merger Arbitrage Funds

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 152

Distressed Securities Funds
• Distressed debt hedge funds invest in the securities of a corporation
that is in bankruptcy or is likely to fall into bankruptcy
• Bankruptcy of a firm occurs when the value of liabilities exceeds the
value of assets
• Once bankruptcy has been declared, the firm may be liquidated
(Chapter 7) or reorganized (Chapter 11)
• Claims are paid by seniority
• Investment in distressed securities require active engagement

Prof. Dr. Marcel Prokopczuk Alternative Investments 153

Searching for Distressed Undervalued
Securities
• The prices of debt in distressed firms can trade substantially below
face value before and during the bankruptcy process
• The job of a distressed investor sounds simple: Estimate the recovery
value
• The recovery value of the firm and its securities is the value of each
security in the firm and is based on the time it will take the firm to
emerge from the bankruptcy process and the condition in which it
will emerge

Prof. Dr. Marcel Prokopczuk Alternative Investments 154

Short Sales of Equity as Writing Naked Call
Option
• One strategy involves to identify firms that are likely to go bankrupt in
the future and to short-sell their stocks
• Since buying stocks can be seen as call option on the firm’s assets,
short-selling is nothing else than selling naked call options
• The main risk is that the fortune of the firm suddenly improves,
leading to substantial losses

Prof. Dr. Marcel Prokopczuk Alternative Investments 155

Capital Structure Arbitrage
• Unhedged positions in distressed firms, involve relatively high risk
• Most hedge fund managers typically use a hedging strategy known as
capital structure arbitrage
• Capital structure arbitrage involves offsetting positions within a
company’s capital structure with the goal of being long relatively
underpriced securities, being short overpriced securities, and being
hedged against risk
• Two standard distressed security investment strategies are (1) to buy
the senior secured debt and short the junior subordinated debt, or (2)
to buy the preferred stock and short the common stock.
Prof. Dr. Marcel Prokopczuk Alternative Investments 156
Event-Driven Multistrategy Funds
• Event-driven multistrategy funds diversify across a wide variety of
event-driven strategies, participating in opportunities in both
corporate debt and equity securities
• Merger activity and debt defaults occur in waves or cycle
• Because these two strategies are countercyclical to each other, many
managers mix a number of event-driven strategies into a single funds
• This combination can increase the capacity of the fund to manage
higher levels of assets, as well as smooth out the opportunity set over
time and various market conditions

Prof. Dr. Marcel Prokopczuk Alternative Investments 157

Relative Value Strategies
• Relative value strategies attempt to capture alpha through predicting
changes in relationships between prices or between rates
• Relative value fund managers take long and short positions that are
relatively equal in size, volatility, and other risk exposures
• Four styles will be discussed
• convertible bond arbitrage
• volatility arbitrage
• fixed-income arbitrage
• relative value multistrategy funds

Prof. Dr. Marcel Prokopczuk Alternative Investments 158

Convertible Bond Arbitrage
• The classic convertible bond arbitrage trade is to purchase a
convertible bond that is believed to be undervalued and to hedge its
risk using a short position in the underlying equity
• Convertible bonds are hybrid corporate securities
• It can be considered as a portfolio of a straight corporate bond and a
call option on the equity

Prof. Dr. Marcel Prokopczuk Alternative Investments 159

Convertible Bond’s Conversion Premium
• Convertible Bond Price = Value of Straight Bond + Value of Call
• Conversion Ratio = Number of Shares per Convertible Bond
• Option Strike Price = Convertible Bond face Value / Conversion Ratio
• Conversion Value = Current Stock Price x Conversion Ratio
• Conversion Premium
= (Convertible Bond Price – Conversion Value) / Conversion Value

Prof. Dr. Marcel Prokopczuk Alternative Investments 160

Busted, Hybrid, and Equity-Like Convertibles
• The characteristics of convertible bonds vary widely with the
moneyness
• Bonds with very high conversion premiums are often called busted
convertibles (out-of-the-money)
• Bonds with very low conversion premiums have stock options that are
deep in-the-money, they are equity-like convertible
• Convertible bonds with moderately sized conversion ratios have stock
options closer to being at-the-money and are called hybrid
convertibles

Prof. Dr. Marcel Prokopczuk Alternative Investments 161

Convertible Bond: Illustration

Bond floor

Conversion
Premium

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 162

Delta, Gamma, and Theta
• The concepts of delta and gamma are keys to understanding the
convertible arbitrage strategy
• Delta is the change in the value of an option (or a security with an
implicit option) with respect to a change in the value of the
underlying asset
• Gamma measures how delta changes as the price of the underlying
asset changes
• Theta is the first derivative of an option’s price with respect to the
time to expiration of the option

Prof. Dr. Marcel Prokopczuk Alternative Investments 163

Stylized Illustration of Convertible Arbitrage
• Consider a $1,000 face value convertible bond that can be converted
into one share of stock
• The stock currently sells for about $1,000, so the implicit option is at-
the-money

Example of a Delta-Neutral Position in Stocks and Convertible Bonds

Stock Price $960 $980 $1,000 $1,020 $1,040
Convertible bond price $1,085 $1,090 $1,100 $1,110 $1,125
Long 1 bond and short 0.5 shares $605 $600 $600 $600 $605

Prof. Dr. Marcel Prokopczuk Alternative Investments 164

Delta Hedging of Convertible Bond
• Delta hedge does not work perfectly
• Needs to be adjusted dynamically

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 165

Convexity

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 166

Sources of Returns to Convertible Bond
Arbitrage
• There are two elements necessary to support the argument that
convertible bonds should consistently offer superior risk-adjusted
returns
• First, demand to buy convertible bonds must be restricted such that it
prevents convertible bond prices from increasing to the point of
offering normal risk-adjusted returns
• Second, suppliers of convertible bonds (corporations) must be of
sufficient size to suppress convertible bond prices to the point of
allowing superior returns

Prof. Dr. Marcel Prokopczuk Alternative Investments 167

Sources of Returns to Convertible Bond
Arbitrage (II)
• Reasons for corporates to offer corporate bonds at attractive prices
• Corporate managers may underestimate the true costs of issuing
convertible bonds
• Convertible bonds are rarely registered in a public offering
• Convertible bonds benefit from increased volatility, thus their interest
is aligned with equity holders, reducing agency costs
• Corporates may use convertible bonds as a (cheaper) way to issue
new equity

Prof. Dr. Marcel Prokopczuk Alternative Investments 168

Return Drivers of Convertible Bond Arbitrage
Risk Position Effect
Interest Long convertible bond, long Convertible bonds have an exposure to risk-free interest rates. As rates rise, bond prices fall.
rates duration, long convexity Some funds hedge these risks through the use of sovereign bond futures or interest rate swaps.
Equity and Short stock, delta-neutral, When the convertible bond arbitrage manager takes a short equity position of the appropriate
volatility long gamma, long vega, long size, the equity risk of the convertible bond is hedged. The embedded long positions in vega and
theta gamma can increase profits when volatility rises. However, the passage of time works against the
investor, as the option’s time value, measured by theta, decays over time.
Correlation Long bond-equity The strategy is long correlation: When interest rates rise, losses may be offset by gains on the
correlation short equity positions. When interest rates fall, losses on the short equity position offset the
fixed-income gains. When correlation declines, stock and bond prices move in opposite
directions, causing losses on both components of the convertible bond.
Credit Long convertible, short Convertible bonds have an exposure to credit risk. As credit spreads widen, bond prices fall. All
equity bonds have a senior claim relative to equities during bankruptcy proceedings.
Legal Long convertible Adverse regulatory rulings can negatively affect convertible bond arbitrageurs. Reductions in
leverage ratios, short-selling restrictions, and accounting changes that make convertible issuance
more restrictive can cause unexpected losses for arbitrageurs.
Liquidity Short equity, long Convertible bond investors sell economic disaster insurance as credit spreads widen during times
and crisis convertible of economic crisis. Convertible bond arbitrageurs are exposed to liquidity risks, such as equity
short squeezes, widening bid-ask spreads of convertible bonds, and increases in both the short
stock borrowing rate and the prime broker borrowing rate.
Source: CAIA Level I learning material (Adapted from Alexander Ineichen
(2003), Absolute Returns (Hoboken, NJ: John Wiley & Sons))
Prof. Dr. Marcel Prokopczuk Alternative Investments 169
Historical Returns of Convertible Arbitrage Funds

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 170

Volatility Arbitrage
• Trading on the basis of prices is as old as money itself
• The concept of explicitly trading on the basis of asset price volatility is
relatively new
• Volatility arbitrage is any strategy that attempts to earn a superior
and riskless profit based on prices that explicitly depend on volatility
• A key concept in volatility arbitrage and options in general is vega
• A key distinction in volatility involves differences between implied
volatility, anticipated volatility, and realized volatility

Prof. Dr. Marcel Prokopczuk Alternative Investments 171

Stylized Observations Regarding Volatility
1. Volatility is not constant, but it mean-reverts, clusters, and has long
memory. As such, many traders will model volatility using a regime-
switching model.
2. Volatility tends to stay low for some extended period of time until a
market shock occurs and volatility transitions to a higher level for some
period of time.
3. The volatility of volatility can be high, but in the long run, volatility tends
to revert toward some long-term average level.
4. In equity markets, volatility tends to increase as price levels decline.
5. Volatility tends to rise more quickly in response to stock prices falling
than it falls in response to stock prices rising.
Source: Euan Sinclair (2013), Volatility
Trading (Hoboken, NJ: John Wiley & Sons)

Prof. Dr. Marcel Prokopczuk Alternative Investments 172

Instruments Used by Volatility Arbitrage Funds
• Managers of volatility arbitrage funds have substantial latitude in the
choice of assets to trade in their funds
• These assets include exchange-traded options, warrants, convertible
bonds, other bonds with embedded options, over-the-counter (OTC)
options, and OTC variance swaps
• In recent years, a robust exchange-traded market has arisen in
volatility futures and options, trading specifically on the Chicago
Board Options Exchange (CBOE) Volatility Index (VIX), which measures
the implied volatility of options on the S&P 500 Index

Prof. Dr. Marcel Prokopczuk Alternative Investments 173

Variance Swaps
• Variance swaps are forward contracts in which one party agrees to
make a cash payment to the other party based on the realized
variance of a price or rate in exchange for receiving a predetermined
cash flow

Variance Swap Payoff =Notional × (Realized Variance − Strike Variance)

• The attraction to variance swaps is that they offer a pure play on asset
return variance without exposure to the direction of moves in the
underlying instrument.

Prof. Dr. Marcel Prokopczuk Alternative Investments 174

Volatility Strategies
• Two main types of volatility arbitrage funds: those that are market (volatility)
neutral and those that are intentionally exposed—typically long—to volatility
• An example of a long volatility strategy is a variance buyer in a variance swap
• Long volatility funds can provide valuable tail risk protection during times of
rising volatility, when markets are likely to decline
• Market-neutral volatility funds have noexposure to changes in volatility levels
• An example of a market-neutral volatility strategy would be offsetting
positions in two options with different implied volatilities in the same or
similar underlying assets. The profit or loss is primarily driven by changes in
the relationship between the two implied volatilities rather than the level of
volatilities
Prof. Dr. Marcel Prokopczuk Alternative Investments 175
Dispersion Trade
• The classic dispersion trade is a market-neutral short correlation trade,
popular among volatility arbitrage practitioners, that typically takes long
positions in options listed on the equities of single companies and short
positions in a related index option
• The key to the dispersion trade is the relationship between a portfolio of
options and a single option on a portfolio
• Individual assets are not highly correlated with each other, so the realized
volatility of individual assets tends to be substantially higher than the
realized volatility of a related index
• The classic dispersion trade is that realized correlations between assets will
be lower than the correlation implied by the pricing of index options
relative to options on individual assets.
Prof. Dr. Marcel Prokopczuk Alternative Investments 176
Summary of Volatility Arbitrage Risks

Risk Effect
Underlying markets: equity, Market-neutral volatility arbitrage funds seek to minimize risks to underlying markets
credit, commodity, currency, through delta-hedging trades. Tail risk funds may retain substantial exposure to changes in
and interest rates underlying markets.
Correlation Market-neutral and dispersion trades are short correlation trades that seek to benefit from
market convergence. Tail risk funds are long correlation trades, seeking to benefit during
times of market crisis.
Volatility Market-neutral funds try to minimize volatility exposure, seeking to take offsetting long and
short volatility positions. Tail risk funds typically benefit during times of rising volatility.
Counterparty Exchange-traded positions have minimal counterparty risks, whereas OTC trades can incur
substantial counterparty risks, which need to be monitored and controlled.
Liquidity Some positions, especially those in credit instruments and structured products, incur
substantial liquidity risks. Trades placed on exchange-traded markets have much lower
liquidity risks.

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 177

Historical Returns of Relative Value Volatility
Funds

Prof. Dr. Marcel Prokopczuk Alternative Investments 178

Fixed-Income Arbitrage
• Fixed-income arbitrage involves simultaneous long and short positions
in fixed-income securities with the expectation that over the
investment holding period, the security prices will converge toward a
similar valuation standard
• At the core of any arbitrage strategy is a model of how prices should
behave
• This model may be based on theory, empirical observations, or both
• The arbitrage is often performed on a pair of securities with a long
position in one security offset by a short position in the other security.
However, the arbitrage can involve any number of longs and shorts

Prof. Dr. Marcel Prokopczuk Alternative Investments 179

Types of Fixed-Income Arbitrage Strategies
• Intracurve arbitrage positions, e.g. steepening of the yield curve
• Intercurve arbitrage positions, e.g. carry trades
• Carry trades attempt to earn profits from carrying or maintaining long
positions in higher-yielding assets and short positions in lower-
yielding assets without suffering from adverse price movements
• Fixed-income arbitrage funds are often differentiated by the markets
in which they speculate
• These markets fall into a number of categories, including sovereign
debt and asset-backed or mortgage-backed securities

Prof. Dr. Marcel Prokopczuk Alternative Investments 180

Asset-Backed and Mortgage-Backed Securities
Strategies
• Asset-backed securities (ABS), which are securitized products created
from pools of underlying loans or other assets
• These loans are originally issued for a variety of purposes, including
credit cards, university tuition, automobiles, and mortgages on
residential and commercial properties (MBS)
• Mortgage-backed securities have complex risks that are driven not
just by changes in interest rate levels but also by changes in the shape
of the yield curve, the prepayment rates of borrowers, and the
default rates of borrowers

Prof. Dr. Marcel Prokopczuk Alternative Investments 181

Risks of Asset-Backed and Mortgage-Backed
Securities Arbitrage
Risk Effect
Interest ABS and MBS are securitized products for which investors have short call options on the underlying pool of bonds.
rates/duration Duration lengthens in times of rising rates, and duration declines in times of falling rates. This duration extension
and contraction is exactly the opposite exposure desired by investors.
Credit spreads ABS and MBS are pools of loans made to consumers borrowing to purchase homes, automobiles, or consumer
products. As such, ABS and MBS investors assume the credit risks of these underlying loans. The credit risks of some
MBS are guaranteed by agencies of the US government, whereas investors retain all of the credit risk of student
loans, automobile loans, and credit card pools.
Prepayment risk Consumers who borrow to purchase a home have the option to refinance their loan at any time. MBS investors need
to accurately model the size and timing of refinancing activity. Prepayment risk is heightened during times of falling
interest rates and robust refinancing activity.
Volatility/convexity MBS and ABS securitized products contain embedded short call options, causing bond prices at or above par to
experience negative convexity. As interest rate volatility rises, the risk of prepayments and the degree of negative
convexity can increase.
Liquidity and crises MBS and ABS can substantially underperform sovereign debt during times of a market crisis and a flight-to-quality
investor response. Due to the complexity of these issues, as well as the embedded options and credit risks, liquidity
of ABS and MBS can decline substantially, whereas OAS can increase dramatically during crisis markets.

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 182
Historical Returns of Fixed-Income Arbitrage
Strategies

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 183

Equity Hedge Funds
• Equity hedge funds follow the most popular hedge fund strategy
• At their heart, equity hedge funds of all styles share a common
strategy focused on taking long positions in undervalued stocks and
short positions in overvalued stocks
• Equity long/short funds tend to have net positive systematic risk
exposure
• Equity market-neutral funds attempt to balance short and long
positions
• Short-bias funds have larger short positions than long positions

Prof. Dr. Marcel Prokopczuk Alternative Investments 184

Equity Hedge Funds: Sources of Return
• Providing liquidity: Hedge funds act as counterparty for liquidity
seekers
• Providing informational efficiency: Hedge funds implement trades
based on new information, e.g. they can more easily short sell
• Identifying factors that can create profit opportunities, e.g. the value
premium of the Fama-French model

Prof. Dr. Marcel Prokopczuk Alternative Investments 185

Market Anomalies
• Investment strategies that can be identified based on available
information and that offer higher expected returns after adjustment
for risk are known as market anomalies, which are violations of
informational market efficiency
• In the equity markets, these anomalies focus on such attributes as
value, market capitalization, accounting accruals, price momentum or
reversal, earnings surprise, net stock issuance, and insider trading.
Good overviews of all anomalies, including the segregation of
performance across the micro-cap, small-cap, and large-cap stock
sectors

Prof. Dr. Marcel Prokopczuk Alternative Investments 186

Integrating Anomalies Using Factor Models
• Equity hedge fund managers do not typically select a single anomaly
that governs all trading decisions, but use factor models
• To integrate a set of anomalies into a single trading signal, a manager
assigns scores to each stock based on each anomaly
• Multiple-factor scoring models combine the factor scores of a
number of independent anomaly signals into a single trading signal
• There are two reasons that equity managers may prefer multifactor
approaches over strategies based on single anomalies
• Higher return potential
• Better diversification
Prof. Dr. Marcel Prokopczuk Alternative Investments 187
Integrating Anomalies Using Pairs Trading
• Pairs trading is a strategy of constructing a long-short portfolio with
matching stocks in terms of systematic risks
• Go long the undervalued stock, and short the overvalued
• Since the portfolio is market-neutral, it is not influenced by market
trends
• If the prices of the stocks converge, a profit will be realized

Prof. Dr. Marcel Prokopczuk Alternative Investments 188

Limits to Arbitrage
• Why do anomalies continue to exist?
• One potential (an plausible) answer is Limits to Arbitrage
• The limits to arbitrage refer to the potential inability or unwillingness
of speculators, such as equity hedge fund managers, to hold their
positions without time constraints or to increase their positions
without size constraints
• These include limited risk-taking capacity, time constraints, market
impact, short selling constraints, etc.

Prof. Dr. Marcel Prokopczuk Alternative Investments 189

Summary of Equity Hedge Fund Risks
Risk Effect
Equity markets Long/short equity funds typically maintain net long exposure to equity markets, whereas short-bias
equity funds maintain net short exposure. As such, long/short equity funds can post losses in bear
markets, and short-bias funds can post losses in bull markets.
Quantitative Quantitative, or black box, models assume that stock prices behave according to a specified factor
versus model. If stock prices do not react as expected, equity hedge fund strategies may produce a negative
fundamental alpha. Similarly, fundamental strategies rely on the judgment of a person or a team, which may or may
not add value in a given market environment.

Concentrated As position sizes become larger and the market capitalization of the stocks declines, managers may
positions and find that their trades have significant market impact. As a risk management tool, a limit on position
liquidity sizes relative to average daily volume in a specific stock should be implemented.

Regulatory Restrictions on short selling, from the uptick rule to periodic bans on short positions, can have a
substantial impact on equity hedge fund strategies.

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 190

Historical Returns of Equity Market-Neutral
Funds

Source: CAIA Level I learning material

Prof. Dr. Marcel Prokopczuk Alternative Investments 191

Funds of Hedge Funds
• Funds of funds are hedge funds with an underlying portfolio of other
hedge funds
• The primary advantages of a fund of funds are diversification,
professional manager selection, and portfolio management processes
• The primary disadvantage of a fund of funds is a second layer of fees
imposed by the fund of funds manager
• At the end of 2020, Hedge Fund Research (HFR) estimated that the
industry was composed of 8,054 single hedge funds and 1,113 funds
of funds

Prof. Dr. Marcel Prokopczuk Alternative Investments 192

Estimated Strategy Composition by Assets
Under Management

Source: CAIA Level I learning material, HFR

Industry Reports, HFR, Inc. ©
2020, http://www.hedgefundresearch.com

Prof. Dr. Marcel Prokopczuk Alternative Investments 193

Functions of Fund of Funds Management
• Strategy and manager selection: The FoF manager is responsible for
selecting the strategies and the managers who will implement those
strategies
• Portfolio construction: Once the strategies and managers have been
selected, the FoF manager has to decide on how much to allocate to each
strategy and manager
• Risk management and monitoring: The FoF manager will monitor each
hedge fund to ensure that its ongoing performance profile is consistent
with the fund’s overall objectives
• Due diligence: For hedge fund investing, due diligence is the process of
monitoring and reviewing the management and operations of a hedge fund
manager
Prof. Dr. Marcel Prokopczuk Alternative Investments 194
Benefits to Investing in Funds of Funds
• Diversification • Negotiated fees
• Accessibility • Regulation
• Economies of scale • Currency hedging
• Information advantage • Leverage
• Liquidity • Educational role
• Access to certain managers

Prof. Dr. Marcel Prokopczuk Alternative Investments 195

Disadvantages to Investing in Funds of Funds
• Double layer of fees
• Performance fees not netted
• Taxation
• Lack of transparency
• Exposure to other investors’ cash flow
• Lack of control

Prof. Dr. Marcel Prokopczuk Alternative Investments 196