001

Table of Contents
 
Title Page
Copyright Page
Preface
FOUNDATION
BENEFITS
THE CAIA PROGRAMS AND CAIA ALTERNATIVE INVESTMENT ANALYST SERIES
 
Part I - Introduction to Alpha Drivers and Beta Drivers
 
Chapter 1 - What Is an Alternative Asset Class?
 
SUPER ASSET CLASSES
REAL ESTATE
ASSET ALLOCATION
OVERVIEW OF THIS BOOK
 
Chapter 2 - Why Alternative Assets Are Important
 
STRATEGIC VERSUS TACTICAL ASSET ALLOCATION
SEPARATING ALPHA FROM BETA
RETHINKING ASSET ALLOCATION
SUMMARY
 
Chapter 3 - The Beta Continuum
 
INTRODUCTION
CLASSIC BETA
BESPOKE BETA
ALTERNATIVE BETA
FUNDAMENTAL BETA
CHEAP BETA
ACTIVE BETA
BULK BETA
SUMMARY: THE BETA CONTINUUM
 
Chapter 4 - Alpha versus Beta
 
INTRODUCTION
ANOTHER DEMONSTRATION OF BETA VERSUS ALPHA DRIVERS
PRODUCT INNOVATORS, PROCESS DRIVERS, AND BESPOKE BETA
SHERLOCK HOLMES AND THE CASE OF ALPHA GENERATION
MARKETS ARE NEVER FULLY EFFICIENT
IS ALPHA A ZERO-SUM GAME?
GOVERNANCE MODEL FOR ALPHA AND BETA SEPARATION
CONCLUSION: EVOLUTION IS A NECESSITY
 
Chapter 5 - The Calculus of Active Management
 
INTRODUCTION
FUNDAMENTAL LAW OF ACTIVE MANAGEMENT
SOME REAL-LIFE EXAMPLES
BENCHMARKS FOR ALTERNATIVE ASSETS
RISK MANAGEMENT
THE TRANSFER COEFFICIENT
130/30 EQUITY PORTFOLIOS
CONCLUSION
References
 
Part II - Real Estate
Chapter 6 - Real Estate Investment Trusts
 
INTRODUCTION
ADVANTAGES OF REITs
DISADVANTAGES OF REITs
DIFFERENT TYPES OF REITs
REIT RULES
ECONOMICS OF REITs
CONCLUSION
 
Chapter 7 - Introduction to NCREIF and the NCREIF Indexes
 
INTRODUCTION
THE NCREIF PROPERTY INDEX (NPI)
CONCLUSION
 
Chapter 8 - Real Estate as an Investment
 
INTRODUCTION
THE BENEFITS OF REAL ESTATE INVESTING
REAL ESTATE PERFORMANCE
REAL ESTATE RISK PROFILE
REAL ESTATE AS PART OF A DIVERSIFIED PORTFOLIO
CONCLUSION
 
Chapter 9 - Core, Value-Added, and Opportunistic Real Estate
 
INTRODUCTION
THE NCREIF STYLE BOXES
RETURN EXPECTATIONS
PRIVATE EQUITY REAL ESTATE
CONCLUSION
 
Part III - Hedge Funds
Chapter 10 - Introduction to Hedge Funds
 
CATEGORIES OF HEDGE FUNDS
A BRIEF HISTORY OF HEDGE FUNDS
HEDGE FUND STRATEGIES
CONCLUSION
 
Chapter 11 - Establishing a Hedge Fund Investment Program
 
SHOULD HEDGE FUNDS BE PART OF AN INVESTMENT PROGRAM?
IS HEDGE FUND PERFORMANCE PERSISTENT?
DO HEDGE FUNDS UNDERMINE THE FINANCIAL MARKETS?
HEDGE FUND INVESTMENT STRATEGIES WITHIN AN INVESTMENT PROGRAM
CONCLUSION
 
Chapter 12 - Due Diligence for Hedge Fund Managers
 
THREE FUNDAMENTAL QUESTIONS
STRUCTURAL REVIEW
STRATEGIC REVIEW
PERFORMANCE REVIEW
RISK REVIEW
ADMINISTRATIVE REVIEW
LEGAL REVIEW
REFERENCE CHECKS
MEASURING OPERATIONAL RISK
CONCLUSION
 
Chapter 13 - Risk Management Part I: Hedge Fund Return Distributions
 
A REVIEW OF HEDGE FUND STUDIES
HEDGE FUND RETURN DISTRIBUTIONS
IMPLICATIONS FOR RISK MANAGEMENT
CONCLUSION
 
Chapter 14 - Risk Management Part II: More Hedge Fund Risks
 
PROCESS RISK
MAPPING RISK
TRANSPARENCY RISK
RISK MANAGEMENT RISK
DATA RISK
PERFORMANCE MEASUREMENT RISK
EVENT RISK
BETA EXPANSION RISK
SHORT VOLATILITY RISK
MULTIMOMENT OPTIMIZATION
CONCLUSION
 
Chapter 15 - Hedge Fund Benchmarks and Asset Allocation
 
HEDGE FUNDS AS AN INVESTMENT
ISSUES WITH HEDGE FUND INDEX CONSTRUCTION
HEDGE FUND INDICES
ASSET ALLOCATION WITH HEDGE FUND INDICES
CONCLUSION
 
Chapter 16 - Hedge Fund Incentive Fees and the Free Option
 
HEDGE FUND INCENTIVE FEES
HEDGE FUND FEES AND OPTION THEORY
DATA AND RESULTS
CONCLUSIONS AND IMPLICATIONS
 
Chapter 17 - Hedge Fund Collapses
 
AMARANTH HEDGE FUND
PELOTON PARTNERS HEDGE FUND
CARLYLE CAPITAL CORPORATION
BAYOU MANAGEMENT
MARIN CAPITAL
BERNIE MADOFF
CONCLUSION
 
Chapter 18 - Top Ten Hedge Fund Quotes
 
NUMBER 10: “IF WE DON’T CHARGE 2 AND 20, NOBODY WILL TAKE US SERIOUSLY.”
NUMBER 9: “WE CHARGE 3 AND 30 BECAUSE THAT IS THE ONLY WAY WE CAN KEEP OUR ...
NUMBER 8: “WE ARE 75% CASH BECAUSE WE CANNOT FIND SUFFICIENT INVESTMENTS.”
NUMBER 7: “WE DON’T INVEST IN CROWDED SHORTS.”
NUMBER 6: “I HAVEN’T SHORTED BEFORE, BUT I DO HAVE MY CAIA.”
NUMBER 5: “HEDGE FUNDS ARE BETTER INVESTMENTS THAN MANAGED FUTURES BECAUSE ...
NUMBER 4: “WHAT’S A MASTER TRUST?”
NUMBER 3: “YOUR HEAD OF EQUITY DOES NOT UNDERSTAND OUR HEDGE FUND STRATEGY.”
NUMBER 2: “BASICALLY I LOOK AT SCREENS ALL DAY AND GO WITH MY GUT.”
AND THE NUMBER 1 TOP TEN QUOTE: “HE WILL BE WITH YOU IN JUST A MINUTE, SIR—HE’S ...
CONCLUSION
References
 
Part IV - Commodities and Managed Futures
Chapter 19 - Introduction to Commodities
 
EXPOSURE TO COMMODITIES
RELATIONSHIP BETWEEN FUTURES PRICES AND SPOT PRICES
ECONOMICS OF THE COMMODITY MARKETS: NORMAL BACKWARDATION VERSUS CONTANGO
COMMODITY PRICES COMPARED TO FINANCIAL ASSET PRICES
CONCLUSION
 
Chapter 20 - Investing in Commodity Futures
 
ECONOMIC RATIONALE
EMPIRICAL EVIDENCE SUPPORTING COMMODITY FUTURES AS AN ASSET CLASS
COMMODITY FUTURES INDICES
CONCLUSION
 
Chapter 21 - Commodity Futures in a Portfolio Context
 
ECONOMIC SUMMARY OF COMMODITY FUTURES
COMMODITY FUTURES AND THE EFFICIENT INVESTMENT FRONTIER
COMMODITY FUTURES AS A DEFENSIVE INVESTMENT
CONCLUSION
 
Chapter 22 - Managed Futures
 
HISTORY OF MANAGED FUTURES
PRIOR EMPIRICAL RESEARCH
RETURN DISTRIBUTIONS OF MANAGED FUTURES
MANAGED FUTURES IN A PORTFOLIO CONTEXT
MANAGED FUTURES AS DOWNSIDE RISK PROTECTION FOR STOCKS AND BONDS
CONCLUSION
 
Part V - Private Equity
Chapter 23 - Introduction to Venture Capital
 
HISTORY OF VENTURE CAPITAL
ROLE OF A VENTURE CAPITALIST
THE BUSINESS PLAN
CURRENT STRUCTURE OF THE VENTURE CAPITAL INDUSTRY
STAGES OF FINANCING
THE J CURVE FOR A START-UP COMPANY
VENTURE CAPITAL CASE STUDY: CACHEFLOW INC./BLUE COAT SYSTEMS
CONCLUSION
 
Chapter 24 - Introduction to Leveraged Buyouts
 
HISTORY OF LBOs
THEORETICAL EXAMPLE OF A LEVERAGED BUYOUT
HOW LBOs CREATE VALUE
THE FAILED LBO
LBO FUND STRUCTURES
PROFILE OF AN LBO CANDIDATE
VENTURE CAPITAL VERSUS LEVERAGED BUYOUTS
RISKS OF LEVERAGED BUYOUTS
CORPORATE GOVERNANCE AND LBOs
THE DISMANTLING OF CONGLOMERATES
MERCHANT BANKING
CONCLUSION
 
Chapter 25 - Debt as Private Equity Part I: Mezzanine Debt
 
OVERVIEW OF MEZZANINE DEBT
EXAMPLES OF MEZZANINE FINANCING
INVESTORS IN MEZZANINE DEBT
CONCLUSION
 
Chapter 26 - Debt as Private Equity Part II: Distressed Debt
 
GROWTH OF THE DISTRESSED DEBT MARKET
VULTURE INVESTORS AND HEDGE FUND MANAGERS
DISTRESSED DEBT AND BANKRUPTCY
DISTRESSED DEBT INVESTMENT STRATEGIES
RISKS OF DISTRESSED DEBT INVESTING
CONCLUSION
 
Chapter 27 - Trends in Private Equity
 
INDUSTRY GROWTH AND MATURATION
SECONDARY PRIVATE EQUITY MARKET
NEW TRENDS IN PRIVATE EQUITY
PRIVATE INVESTMENTS IN PUBLIC EQUITY (PIPEs)
CONCLUSION
 
Chapter 28 - The Economics of Private Equity
 
PERFORMANCE OF PRIVATE EQUITY
PRIVATE EQUITY RETURN DISTRIBUTIONS
PRIVATE EQUITY WITHIN A DIVERSIFIED PORTFOLIO
CONCLUSION
 
Part VI - Credit Derivatives
Chapter 29 - Introduction to Credit Derivatives
 
THREE SOURCES OF CREDIT RISK
CREDIT-RISKY INVESTMENTS
CREDIT OPTION DERIVATIVES
CREDIT DEFAULT SWAPS
CONCLUSION
 
Chapter 30 - Collateralized Debt Obligations
 
GENERAL STRUCTURE OF CDOs
BALANCE SHEET CDO STRUCTURES
ARBITRAGE CDOs
CDO LIFE CYCLE
EXAMPLE OF A CDO STRUCTURE
CONCLUSION
 
Chapter 31 - Risks and New Developments in CDOs
 
NEW DEVELOPMENTS IN CDOs
RISKS OF CDOs
A CASE STUDY OF CDO RISK
CONCLUSION
Appendix A - Basic Principles of Return and Present Value
Appendix B - Measures of Risk and Risk Management
Appendix C - Correlation and Regression Analysis
Appendix D - The Quantitative Analysis of 130/30 Products
About the Authors
Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more.
For a list of available titles, visit our Web site at www.WileyFinance.com.

001

Preface
Since its inception in 2002, the Chartered Alternative Investment Analyst (CAIA) Association has strived to incorporate state-of-the-art reading materials in its curriculum. This latest curriculum reading, part of the Chartered Alternative Investment Analyst Series, represents a milestone in our efforts to continuously improve and update our curriculum. To ensure that the material best reflects current practices in the area of alternative investments, the CAIA Association invited a group of leading industry professionals to contribute to the production of the series, covering core areas of alternative investments: hedge funds, managed futures, commodities, real estate, and private equity. Similar to other books published by the CAIA Association, this book is grounded in the CAIA Program Core Knowledge OutlineSM. Mark Anson, CAIA, has been contributing to the development of the CAIA curriculum since the Association’s beginnings. He brings more than 20 years of experience in alternative assets to writing this first book in our series. We are proud to make this book available to our candidates and alternative investment professionals. This first edition of the series is being launched in 2009 when more than 5,000 aspiring, as well as accomplished, alternative investment professionals will endeavor to master the material covered in this book, as well as other readings as outlined in the CAIA study guides, in order to earn the prestigious CAIA designation.
In publishing the books in this series, we are guided by the Association’s mission to provide its members with a comprehensive knowledge of alternative investments, advocate high standards of professional conduct, and establish the Chartered Alternative Investment Analyst designation as the educational gold standard for the alternative investment industry.

FOUNDATION

The quality, rigor, and relevance of this series derive from the ideals upon which the CAIA Association was based. The CAIA program offered its first Level I examination in February of 2003. We now have over 3,000 members, but in its first full year only 43 candidates, who passed Level I and Level II exams and met the other requirements of membership, were invited to join the CAIA Association. Many of these founding members were instrumental in establishing the CAIA designation as the global mark of excellence in alternative investment education. Through their support and with the help of the founding co-sponsors, the Alternative Investment Management Association (AIMA) and the Center for the International Securities and Derivatives Markets (CISDM), the Association is now firmly established as the most comprehensive and credible designation in the rapidly growing sphere of alternative investments.
The AIMA is the hedge fund industry’s global, not-for-profit trade association, with over 1,100 corporate members worldwide. Members include leading hedge fund managers, fund of hedge funds managers, prime brokers, legal and accounting services, and fund administrators. They all benefit from the AIMA’s active influence in policy development; its leadership in industry initiatives, including education and sound practice manuals; and its excellent reputation with regulators.
The CISDM of the Isenberg School of Management of the University of Massachusetts seeks to enhance the understanding of the field of alternative investments through research, education, and networking opportunities for member donors, industry professionals, and academics.
I first attended one of the early annual CISDM Research meetings as a CISDM fellow and doctoral student over 10 years ago, and recall being most impressed by the level and depth of discussion among the Center’s sponsors regarding the need for education and research in the area of alternative investments. It has been truly rewarding to witness the development and growth of the CAIA, starting from only an idea to meet a real need.
Led by Craig Asche, Executive Director of the Association; Dr. Thomas Schneeweis, Director of the CISDM; Florence Lombard, of AIMA; and a core group of faculty and industry experts who were associated with the University of Massachusetts and AIMA, the CAIA program took shape and was introduced to the investment community through the publication of its first set of CAIA study guides in 2002. From the beginning, the Association recognized that a meaningful portion of its curriculum must be devoted to codes of conduct and ethical behavior in the investment profession. To this end, with permission and cooperation of the CFA Institute, we have incorporated its Code of Ethics and the CFA Standards of Practice Handbook in our curriculum. Further, we leverage the experience and contributions of our membership and other distinguished alternative investment professionals on our board and committees to create and update the CAIA Program Core Knowledge OutlineSM .
The CAIA Association has experienced rapid growth in its membership during the past seven years—a growth that has followed the expansion of the alternative investment industry into the mainstream of the investment industry. We strive to stay nimble in our process so that curriculum developments remain relevant and keep pace with the constant changes in this dynamic industry. Yet we never lose sight of the fact that we complement the still larger traditional and established investment arena.
This series focuses on the core topics that comprise each of the basic areas of alternative investments, but our original philosophy to stay nimble will serve us especially well now. Given the recent turmoil in the markets, the ability to keep pace with the regulatory and economic changes is more important today than it has ever been in our history. This series, including the annually revised, most advanced material contained in our CAIA Level II: Current and Integrated Topics, reflects the current state of the industry.

BENEFITS

While the CAIA Association’s origins are largely due to the efforts of professionals in the hedge fund and managed futures space, these founders correctly identified a void in the wider understanding of the alternative investments space as a whole. From the beginning, the CAIA curriculum has also covered private equity, commodities, and real estate equally and always with an eye toward shifts in the industry. Today, several hundred CAIA members identify their main area of expertise as real estate or private equity; several hundred more members are from family offices, pension funds, endowments, and sovereign wealth funds that allocate across multiple classes within the alternative space. To accomplish this comprehensively, we have fully developed curriculum subcommittees that represent each area of coverage within the curriculum. All of these alternative investment areas share many distinct features such as the relative freedom on the part of investment managers to act in the best interests of their investors, alignment of interests between investors and management, relative illiquidity of positions for some investment products, and deviations from some of the underpinning assumptions of modern portfolio theory. These characteristics necessitate conceptual and actual modifications to the standard investment performance analysis and decision making paradigms.
The reader will find the publications in our series to be beneficial whether from the standpoint of allocating to new asset classes and strategies in order to gain broader diversification or from the standpoint of a specialist needing to better understand the competing options available to sophisticated investors globally. In either case, the reader will be better equipped to serve his or her clients’ needs. The series has been designed to make studying more efficient relative to our past curriculum. Importantly, it is more relevant, having been written under the direction of the CAIA Association with the input and efforts of many practicing and eminent alternative investment professionals, as reflected in each publication’s acknowledgments section.

THE CAIA PROGRAMS AND CAIA ALTERNATIVE INVESTMENT ANALYST SERIES

The CAIA Prerequisite Program is an assessment tool to determine a candidate’s readiness to enter the CAIA program. These prerequisite materials cover the quantitative analytics commonly associated with traditional assets, as well as a blend of practical and theoretical knowledge relating to both traditional and alternative investments.
The first book in our series, CAIA Level I: An Introduction to Core Topics in Alternative Investments , is a revised edition of Mark Anson’s Handbook of Alternative Assets. This new CAIA edition includes completely updated sections on hedge funds, managed futures and commodities, private equity, and credit derivatives, as well as new chapters on active management and real estate. Thus, the CAIA Level I required readings are contained in this one text, supplemented only by the CFA Institute’s Standards of Practice Handbook. The reader should be aware, however, that the prerequisite program has been expanded, and that Level I candidates are assumed to have mastered all of its content in advance of taking the Level I exam.
The second book in our series, CAIA Level II: Advanced Core Topics in Alternative Investments, also represents a significant improvement to the coverage of our curriculum. Specifically, each section was developed to incorporate the expert practitioner input that comprises the CAIA Program Core Knowledge OutlineSM. We believe this new model of curriculum development accurately reflects the skill set required of industry practitioners.
The third book in the series, CAIA Level II: Integrated Topics and Applications, is the result of the work of our Curriculum Task Force members. They reviewed the newly developed drafts of the first two new books in the series in light of the CAIA Program Core Knowledge OutlineSM, updated the Outline, prioritized and developed supplemental topics, and reviewed practice problems designed for the Level II examinations and included in this publication.
The fourth volume in this series is titled CAIA Level II: Current and Integrated Topics. It is updated annually and designed to address topics that cut across all areas of alternative investments, such as asset allocation and risk management techniques, as well as new developments in the alternative investment research space and in the industry itself.
Finally, we will continue to update the CAIA Level I Study Guide and the CAIA Level II Study Guide every six months (each exam cycle). These are freely available on our web site. These guides outline all of the readings and corresponding learning objectives (LOs) that candidates are responsible for meeting. They also contain important information for candidates regarding the use of LOs, testing policies, topic weightings, where to find and report errata, and much more. The entire exam process is outlined in the CAIA Candidate Handbook and is available at www.caia.org/enroll/candidatehandbook/.
I believe you will find this series to be the most comprehensive, rigorous, and globally relevant source of educational material available within the field of alternative investments.
 
Kathryn Wilkens-Christopher, PhD, CAIA
Director of Curriculum
CAIA Association
July 2009

Part I
Introduction to Alpha Drivers and Beta Drivers

1
What Is an Alternative Asset Class?
Part of the difficulty of working with alternative asset classes is defining them. Are they a separate asset class or a subset of an existing asset class? Do they hedge the investment opportunity set or expand it? Are they listed on an exchange or do they trade in the over-the-counter market?
In most cases, alternative assets are a subset of an existing asset class. This may run contrary to the popular view that alternative assets are separate asset classes.1 However, we take the view that what many consider separate classes are really just different investment strategies within an existing asset class.
Additionally, in most cases, they expand the investment opportunity set, rather than hedge it. Last, alternative assets are generally purchased in the private markets, outside of any exchange. While hedge funds, private equity, and credit derivatives meet these criteria, we will see that commodity futures prove to be the exception to these general rules.
Alternative assets, then, are just alternative investments within an existing asset class. Specifically, most alternative assets derive their value from either the debt or the equity markets. For instance, most hedge fund strategies involve the purchase and sale of either equity or debt securities. In addition, hedge fund managers may invest in derivative instruments whose value is derived from the equity or debt markets.
In this book, we classify five types of alternative assets: real estate, hedge funds, commodity and managed futures, private equity, and credit derivatives. Investments in real estate may be made directly, or indirectly through a fund. Hedge funds and private equity are the best known of the alternative asset world. Typically, these investments are accomplished through the purchase of limited partner units in a private limited partnership. Commodity futures can be either passive investing tied to a commodity futures index or active investing through a commodity pool or advisory account. Private equity is the investment strategy of investing in companies before they issue their securities publicly, or taking a public company private. Credit derivatives can be purchased through limited partnership units, as a tranche of a special purpose vehicle, or directly through the purchase of distressed debt securities.
We will explore each of these alternative asset classes in detail, providing practical advice along with useful research. We begin this chapter with a review of super asset classes.

SUPER ASSET CLASSES

There are three super asset classes: capital assets, assets that are used as inputs to creating economic value, and assets that are a store of value.2

Capital assets

Capital assets are defined by their claim on the future cash flows of an enterprise. They provide a source of ongoing value. As a result, capital assets may be valued based on the net present value of their expected returns.
Under the classic theory of Modigliani and Miller, a corporation cannot change its value (in the absence of tax benefits) by changing the method of its financing.3 Modigliani and Miller demonstrated that the value of the firm is dependent on its cash flows. How those cash flows are divided up between shareholders and bondholders is irrelevant to firm value.
Capital assets, then, are distinguished not by their possession of physical assets, but rather by their claim on the cash flows of an underlying enterprise. Hedge funds, private equity funds, credit derivatives, and corporate governance funds all fall within the super asset class of capital assets because the values of their funds are all determined by the present value of expected future cash flows from the securities in which they invest.
As a result, we can conclude that it is not the types of securities in which they invest that distinguish hedge funds, private equity funds, credit derivatives, or corporate governance funds from traditional asset classes. Rather, it is the alternative investment strategies they pursue that distinguish them from traditional stock and bond investments.

Assets that can be used as economic inputs

Certain assets can be consumed as part of the production cycle. Consumable or transformable assets can be converted into another asset. Generally, this class of assets consists of the physical commodities: grains, metals, energy products, and livestock. These assets are used as economic inputs into the production cycle to produce other assets, such as automobiles, skyscrapers, new homes, and appliances.
These assets generally cannot be valued using a net present value analysis. For example, a pound of copper, by itself, does not yield an economic stream of revenues. Nor does it have much value for capital appreciation. However, the copper can be transformed into copper piping that is used in an office building or as part of the circuitry of an electronic appliance.
While consumable assets cannot produce a stream of cash flows, we will demonstrate in our section on commodities that this asset class has excellent diversification properties for an investment portfolio. In fact, the lack of dependency on future cash flows to generate value is one of the reasons why commodities have important diversification potential vis-à-vis capital assets.

Assets that store value

Art is considered the classic asset that stores value. It is not a capital asset because there are no cash flows associated with owning a painting or a sculpture. Consequently, art cannot be valued in a discounted cash flow analysis. It is also not an asset that is used as an economic input because it is a finished product.
Art requires ownership and possession. Its value can be realized only through its sale and transfer of possession. In the meantime, the owner retains the artwork with the expectation that it will yield a price that in real terms (i.e. adjusted by inflation) is at least equal to what the owner paid for it.
There is no rational way to gauge whether the price of art will increase or decrease because its value is derived purely from the subjective (and private) visual enjoyment that the right of ownership conveys. Therefore, to an owner, art is a store of value. It neither conveys economic benefits nor is used as an economic input, but retains the value paid for it.
Gold and precious metals are another example of a store of value asset. In the emerging parts of the world, gold and silver are a significant means of maintaining wealth. Residents of these countries often do not have access to the same range of financial products that are available to residents of more developed nations. Consequently, they accumulate their wealth through a tangible asset as opposed to a capital asset.
However, the lines between the three super classes of assets can become blurred. For example, gold can be leased to jewelry and other metal manufacturers. Jewelry makers lease gold during periods of seasonal demand, expecting to purchase the gold on the open market and return it to the lessor before the lease term ends. The gold lease provides a stream of cash flows that can be valued using net present value analysis.
Precious metals can also be used as transformable or consumable assets because they have the highest levels of thermal and electrical conductivity among the metals. Silver, for example, is used in the circuitry of most telephones and light switches. Gold is used in the circuitry of TVs, cars, airplanes, computers, and rocket ships.

REAL ESTATE

We include real estate in our discussion of alternative assets even though real estate was an asset class long before stocks and bonds became the investment of choice. In fact, in times past, land was the single most important asset class. Kings, queens, lords, and nobles measured their wealth by the amount of property that they owned. “Land barons” were aptly named. Ownership of land was reserved for only the wealthiest of society.
However, over the past 200 years, our economic society changed from one based on the ownership of property to one based on the ownership of legal entities. This transformation occurred as society moved from the agricultural age to the industrial age. Production of goods and services became the new source of wealth and power.
Stocks and bonds were originated to support the financing needs of new enterprises that manufactured material goods and services. In fact, stocks and bonds became the alternatives to real estate instead of vice versa. With the advent of stock and bond exchanges and the general acceptance of owning equity or debt stakes in companies, it is sometimes forgotten that real estate was the original and primary asset class of society.
In fact, it was only 28 years ago in the United States that real estate was the major asset class of most individual investors. This exposure was the result of owning a primary residence. It was not until the long bull market started in 1983 that investors began to diversify their wealth into the “alternative” assets of stocks and bonds.
Given the long-term presence of real estate as an asset class, several treatises have been written concerning its valuation.4 Still, we believe a discussion of real estate is relevant within the framework of alternative assets. The reason is that other than a primary residence, real estate is often excluded from a diversified portfolio. Perhaps another way to look at real estate is as a fundamental asset class that should be included within every diversified portfolio. Therefore, it is an alternative asset class meant to diversify the stock and bond holdings within a portfolio context.

ASSET ALLOCATION

Asset allocation is generally defined as the allocation of an investor’s portfolio across a number of asset classes.5 Asset allocation, by its very nature, shifts the emphasis from the security level to the portfolio level. It is an investment profile that provides a framework for constructing a portfolio based on measures of risk and return. In this sense, asset allocation can trace its roots to modern portfolio theory and the work of Harry Markowitz.6

Asset classes and asset allocation

Initially, asset allocation involved four asset classes: equity, fixed income, cash, and real estate. Within each class, the assets could be further divided into subclasses. For example, stocks can be divided into large-capitalization stocks, small-capitalization stocks, and foreign stocks. Similarly, fixed income can be broken down into U.S. Treasury notes and bonds, investment-grade bonds, high-yield bonds, and sovereign bonds.
The expansion of newly defined alternative assets may cause investors to become confused about the diversification properties of alternative assets and how they fit into an overall diversified portfolio. Investors need to understand the background of asset allocation as a concept for improving return while reducing risk.
For example, in the 1980s, the biggest private equity game was taking public companies private. Does the fact that a corporation that once had publicly traded stock but now has privately traded stock mean that it has jumped into a new asset class? We maintain that it does not. Furthermore, public offerings are the primary exit strategy for private equity; public ownership begins where private equity ends.7
Considered within this context, a separate asset class does not need to be created for private equity. Rather, this type of investment can be considered as just another point within the equity investment universe. Rather than hedging the equity class as altogether separate, private equity expands the equity asset class.
Similarly, credit derivatives expand the fixed income asset class, rather than hedging it. Hedge funds also invest in the stock and bond markets but pursue trading strategies that are very different from a traditional buy-and-hold strategy. Commodities fall into a different class of assets than equity, fixed income, or cash, and are treated separately in this book.

Strategic versus tactical allocations

Some alternative assets should be used in a tactical rather than strategic allocation. Strategic allocation of resources is applied to fundamental asset classes such as equity, fixed income, cash, and real estate. These are the basic asset classes that must be held within a diversified portfolio.
Strategic asset allocation is concerned with the long-term asset mix. The strategic mix of assets is designed to accomplish a long-term goal such as funding pension benefits or matching long-term liabilities. Risk aversion is considered when deciding the strategic asset allocation but current market conditions are not. In general, policy targets are set for strategic asset classes with allowable ranges around those targets. Allowable ranges are established to allow flexibility in the management of the investment portfolio.
Tactical asset allocation is short-term in nature. This strategy is used to take advantage of current market conditions that may be more favorable to one asset class over another. The goal of funding long-term liabilities has been satisfied by the target ranges established by the strategic asset allocation. The goal of tactical asset allocation is to maximize return.
Tactical allocation of resources depends on the ability to diversify within an asset class. This is where alternative assets have the greatest ability to add value. Their purpose is not to hedge the fundamental asset classes, but rather to expand them. Consequently, alternative assets should be considered as part of a broader asset class.
As already noted, private equity is simply one part of the spectrum of equity investments. Granted, a different set of skills is required to manage a private equity portfolio compared to public equity securities. However, private equity investments simply expand the equity investment universe. Consequently, private equity is an alternative investment strategy within the equity universe as opposed to a new fundamental asset class.
Another example is credit derivatives. These are investments that expand the frontier of credit risk investing. The fixed income world can be classified simply as a choice between U.S. Treasury securities that are considered to be default-free and spread products that contain an element of default risk. Spread products include any fixed income investment that does not have a credit rating on a par with the U.S. government. Consequently, spread products trade at a credit spread relative to U.S. Treasury securities that reflects their risk of default.
Credit derivatives are a way to diversify and expand the universe for investing in spread products. Traditionally, fixed income managers attempted to establish their ideal credit risk and return profile by buying and selling traditional bonds. However, the bond market can be inefficient and it may be difficult to pinpoint the exact credit profile to match the risk profile of the investor. Credit derivatives can help to plug the gaps in a fixed income portfolio and expand the fixed income universe by accessing credit exposure in more efficient formats.

Efficient versus inefficient asset classes

Another way to distinguish alternative asset classes is based on the efficiency of the marketplace. The U.S. public stock and bond markets are generally considered the most efficient marketplaces in the world. These markets are often referred to as semistrong efficient. This means that all publicly available information regarding a publicly traded corporation, both past information and present, is fully digested in the price of that company’s traded securities.
Yet, inefficiencies exist in all markets, both public and private. If there were no informational inefficiencies in the public equity market, there would be no case for active investment management. Nonetheless, whatever inefficiencies do exist, they are small and fleeting. The reason is that information is easy to acquire and disseminate in the publicly traded securities markets. Top-quartile active managers in the public equity market earn excess returns (over their benchmarks) of approximately 1% a year.
In contrast, with respect to alternative assets, information is very difficult to acquire. Most alternative assets (with the exception of commodities) are privately traded. This includes private equity, hedge funds, real estate, and credit derivatives. The difference between top-quartile and bottom-quartile performance in private equity can be as much as 25%.
Consider venture capital, one subset of the private equity market. Investments in start-up companies require intense research into the product niche the company intends to fill, the background of the management of the company, projections about future cash flows, exit strategies, potential competition, beta testing schedules, and so forth. This information is not readily available to the investing public. It is time-consuming and expensive to accumulate. Further, most investors do not have the time or the talent to acquire and filter through the rough data regarding a private company. One reason why alternative asset managers charge large management and incentive fees is to recoup the cost of information collection.
This leads to another distinguishing factor between alternative investments and the traditional asset classes: the investment intermediary. Continuing with our venture capital example, most investments in venture capital are made through limited partnerships, limited liability companies, or special purpose vehicles. It is estimated that 80% of all private equity investments in the United States are funneled through a financial intermediary.
Last, investments in alternative assets are less liquid than their public markets counterparts. Investments are closely held and liquidity is minimal. Further, without a publicly traded security, the value of private securities cannot be determined by market trading. The value of the private securities must be estimated by book value, arrived at by appraisal, or determined by a cash flow model.

Constrained versus unconstrained investing

During the great bull market of 1983 to 2000, the asset management industry only had to invest in the stock market to enjoy consistent double-digit returns. During this heyday, investment management shops and institutional investors divided their assets between the traditional asset classes of stocks and bonds. As the markets turned sour at the beginning of the new millennium, asset management firms and institutional investors found themselves boxed in by these traditional asset class distinctions. They found that their investment teams were organized along traditional asset class lines and their investment portfolios were constrained by efficient benchmarks that reflected this “asset box” approach.
Consequently, traditional asset management shops have been slow to reorganize their investment structures. This has allowed hedge funds and other alternative investment vehicles to flourish because they are not bound by traditional asset class lines—they can invest outside the benchmark. These alternative assets are free to exploit the investment opportunities that fall in between the traditional benchmark boxes. The lack of constraints allows alternative asset managers a degree of freedom that is not allowed the traditional asset class shops. Further, traditional asset management shops remain caught up in an organizational structure that is bounded by traditional asset class lines. This provides another constraint because it inhibits the flow of information and investment ideas across the organization.

Asset location versus trading strategy

One of the first and best papers on hedge funds, by William Fung and David Hsieh,8 shows a distinct difference between how mutual funds and hedge funds operate. They show that the economic exposure associated with mutual funds is defined primarily by where the mutual fund invests. In other words, mutual funds gain their primary economic and risk exposures by the locations of the asset classes in which they invest. Thus, we get large-cap active equity funds, small-cap growth funds, Treasury bond funds, and the like.
Conversely, Fung and Hsieh show that hedge funds’ economic exposures are defined more by how they trade. That is, a hedge fund’s risk and return exposure is defined more by a trading strategy within an asset class than it is defined by the location of the asset class. As a result, hedge fund managers tend to have much greater turnover in their portfolios than mutual funds have.

Asset class risk premiums versus trading strategy risk premiums

Related to the idea of trading strategy versus investment location is the notion of risk premiums. You cannot earn a return without incurring risk. Traditional investment managers earn risk premiums for investing in the large-cap value equity market, small-cap growth equity market, and high-yield bond market, in other words, based on the location of the asset markets in which they invest.
Conversely, alternative asset managers also earn returns for taking risk, but the risk is defined more by a trading strategy than it is by an economic exposure associated with the systematic risk contained within broad financial classes. For example, hedge fund strategies such as convertible arbitrage, statistical arbitrage, and equity market neutral can earn a so-called complexity risk premium.9
These strategies buy and sell similar securities, expecting the securities to converge in value over time. The complexity of implementing these strategies results in inefficient pricing in the market. In addition, many investors are constrained by the long-only restriction—their inability to short securities. This perpetuates inefficient pricing in the marketplace, which enables hedge funds to earn a return.

OVERVIEW OF THIS BOOK

This book is organized into six parts plus four appendices. The first part provides a framework to consider alternative assets within a broader portfolio context. Specifically, in Chapter 2 we expand on the concept of strategic versus tactical asset allocation and the use of beta drivers versus alpha drivers to achieve these goals. Chapter 3 discusses in detail the concept of beta. Just as the market for alternative assets has become more sophisticated over the years, the market for beta has advanced as well. The traditional capital asset pricing model (CAPM) beta is not sufficient to describe the many ways of systematic risk capture that exist in the financial markets today. Further, a discussion of beta will help ground us in the reality and examination of alpha. Chapter 4 examines the separation of alpha and beta in the asset management industry. As investors have become more advanced in their portfolio construction, asset management companies have had to respond by developing a clearer understanding and pricing of beta and alpha. Chapter 5 explains the calculus of active management, which provides a discussion of the Fundamental Law of Active Management.
The second part of the book turns to real estate. Real estate has long been a significant holding of both retail (homeowners) and institutional (commercial, retail, multifamily, industrial) investors. We start in Chapter 6 with a review of real estate investment trusts (REITs). Chapter 7 discusses the formation of the National Council of Real Estate Investment Fiduciaries (NCREIF) and the construction of its National Property Index, the most widely used benchmark in the real estate industry. Chapter 8 takes a step back to discuss the five reasons why real estate is a necessary part of any diversified portfolio. Chapter 9 provides a discussion on the differences between core, value-added, and opportunistic real estate, exploring their different risk profiles and return expectations.
The third part of the book reviews hedge funds. Chapter 10 begins with a brief history on the birth of hedge funds and an introduction to the types of hedge fund investment strategies. Chapter 11 provides some practical guidance as to how to build a hedge fund investment program. Chapter 12 is devoted to conducting due diligence, including both a qualitative and a quantitative review. In Chapter 13, we analyze the return distributions of hedge funds and begin to consider some risk management issues. In Chapter 14, we expand the discussion of hedge fund risks and highlight some specific examples of hedge fund underperformance. Chapter 15 provides an introduction to hedge fund benchmarks and discusses how these benchmarks impact the asset allocation decision with regard to hedge funds. In Chapter 16, we consider the fees charged by hedge fund managers, a key point of contention between hedge fund managers and their clients. Chapter 17 reviews some recent hedge fund explosions and implosions. We thought it worthwhile to look at recent exits of five hedge fund managers to determine what went wrong, to consider what might have been done to prevent their demise, and to see whether there are any other lessons learned. In the concluding Chapter 18, we have a bit of fun at the expense of the hedge fund industry and add a humorous note as we go through a top-ten list of hedge fund quotes (from actual hedge fund managers) and accompanying anecdotes.
Part IV is devoted to commodity and managed futures. We begin with a brief review in Chapter 19 of the economic value inherent in commodity futures contracts. Chapter 20 describes how an individual or institution may invest in commodity futures, including an introduction to commodity futures benchmarks. Chapter 21 considers commodity futures within a portfolio framework, while Chapter 22 examines the managed futures industry.
Part V covers the spectrum of private equity. In Chapter 23, we introduce venture capital, while Chapter 24 is devoted to leveraged buyouts. In Chapters 25 and 26, we show how two different forms of debt may be components of the private equity marketplace. In Chapter 27, we introduce alternative investment strategies within the private equity marketplace, and in Chapter 28, we review the economics associated with private equity investments.
Part VI is devoted to credit derivatives. In Chapter 29, we review the importance of credit risk and provide examples of how credit derivatives are used in portfolio management. In Chapter 30, we review the collateralized debt obligation market. Specifically, we review the design, structure, and economics of collateralized bond obligations and collateralized loan obligations. In Chapter 31, we discuss new developments.
Throughout this book, we attempt to provide descriptive material as well as empirical examples. In each chapter, you will find charts, tables, graphs, and calculations that serve to highlight specific points. Our goal is to both educate the reader with respect to these alternative investment strategies as well as provide a reference book for data and research. Along the way, we also try to provide a few anecdotes about alternative investing that, while providing some humor, also demonstrate some of the pitfalls of the alternative asset universe.

Appendices

The first three appendices cover essential material provided as a reference: Appendix A begins to apply some basic principles of return, compounding, expected return, and internal rate of return. Appendix B turns to measures of risk such as the variance, volatility, skewness, and kurtosis. These are risk measures that we use throughout the book with respect to each alternative investment class. Appendix C provides basic examples of correlation analysis and linear regression analysis. These deal with quantitative methods in finance. As the market has moved toward the separation of beta and alpha, more sophisticated mathematical concepts have been applied to accurately measure and manage alpha and beta. Last, Appendix D explores 130/30 funds, which are all the rage among both institutional and retail investors. Some consider 130/30 funds to be a poor man’s hedge fund, but, in fact, these funds can play a vital part in portfolio construction.

2
Why Alternative Assets Are Important
Beta Drivers and Alpha Drivers
The 1980s and 1990s experienced an unprecedented equity market expansion that provided an average annual total return to the S&P 500 of over 18% per year. It was hard to ignore the premium that the equity market delivered over U.S. Treasury bonds during this time. Over the same period, the average yield to maturity for the 10-year U.S. Treasury bond was 8.63%, a historic high.
The long-term implied equity risk premium (ERP) (over 10-year U.S. Treasury bonds) has been estimated at 3.8%.10 This is the risk premium implied by stock market valuations and forecasts of earnings in relation to current market value. It is the expected risk premium that long-term investors must earn to entice them to hold equities rather than government bonds. However, throughout the 1980s and 1990s, the realized risk premium frequently exceeded that implied by investors’ expectations.
Exhibit 2.1 plots the realized equity risk premium compared to the long-term ERP. It also graphs the cumulative ERP earned over this period. Generally, over the 1980-1999 time period, the realized ERP was inconsistent, sometimes greater than the expected long-term risk premium, sometimes less. However, from the late 1980s through the end of the 1990s, the realized risk premium for holding equities exceeded the expected premium more often than not. As a result, investors were continually rewarded with equity market returns that exceeded their expectations.
This led large institutional investors to rely exclusively on asset allocation models where asset classes were defined by strict lines or so-called benchmark boxes.11 For 20 years, this type of investing worked for large institutional investors. However, the global bear equity market of 2000 to 2002 demonstrated that mean reversion is a powerful force in finance.
12