A LTERNATIVE I NVESMENTS P ORTFOLIO M ANANGEMENT Portfolio Management Prof. Ali Nejadmalayeri

Universe of Investments Universe of Investment Traditional Alternative Investments Modern Alternative Investments Traditional Investments Hedge Funds Managed Futures Distressed Securities Private Equity Commodities Real Estate Stocks Bonds

Concerns Tax Issues Suitability Communication with Client Decision Risk Equity Stakes in Closely Held Companies

Real Estate Type of Investments –Real Estate Investment Trust (REIT) Equity REIT, Mortgage REIT, Hybrid REIT –Commingled Real Estate Fund (CREF) –Infrastructure Fund Benchmarks –NCREIF, measure of direct investment quarterly sample of commercial properties owned by large institutions –NAREIT, measure of indirect investment Real-time, market-cap weighted all REITs in NYSE and AMEX Other indexes as well produced by NAREIT

Real Estate: Characteristics Investment Characteristics –Advantages Tax subsidies, leverage, direct control of assets, geographical diversification, low volatility –Disadvantages Divisibility, information asymmetries, high transaction costs, high operating costs, locality risk Role as a Diversifier –Advantages Some benefit but not when hedge funds and commodities considered –Geographical differences and return persistence

Private Equity/Venture Capital Purpose –Early stage (seed, start-up, first-stage) and Large- stage financing (2 nd, 3 rd and mezzanine financing) Ventures –Angel Investor –Venture Capital Funds and Trusts –Mega- and Mid-Cap Buy-Out Funds Benchmarks –Annualized IRRs by NVCA and Thomson Venture Economics

PE/VC: Characteristics Private Equity Investment Characteristics –Illiquidity –Long-term Commitment –Higher risk than seasonal equity –Higher IRR –Limited Information Private Equity vs. Venture Capital –Buy-out funds are highly levered –Cash flows to BO funds’ investors are often and steady –VC returns are more vague and uncertain

Commodity Funds Types –Direct Commodity Investment Purchase of physical commodities –Indirect Commodity Investment Purchase of commodities-linked companies Benchmarks –Goldman Sachs Commodity Index (GSCI) –S&P Commodity Index (S&PCI) –Dow Jones – AIG Commodity Index (DJ-AIGCI) Benchmarks –Total return = collateral + roll + spot returns

CF: Characteristics Investment Characteristics –Business Cycle related Supply & Demand –Convenience Yield Future – spot = interest rate + storage + convenience –CY is the consumption timing option return –At low levels of inventory CY is high and vice versa –Real Option Yield Backwardation (inverted future price curve) is a sign of real option under uncertainty Role of Commodities –Potential Hedge Against Inflation –Risk Diversifier

Hedge Funds Types –Equity market neutral: short + long positions –Arbitrage Convertible Arbitrage: long CB + short stocks Fixed Income Arbitrage: hedges against direction Merger Arbitrage: long target and shorting acquirer –Distressed Securities: long distressed bonds –Hedged equity: unbalanced short + long –Global macro: major global trends –Emerging markets: long in EM stocks –Fund of funds: combo of hedge funds

Hedge Funds (Cont’d) Benchmarks –Monthly CISDM by the University of Massachusetts, 90 Credit Swiss/Tremont, 94 EACM Advisors, 90 Hedge Fund Intelligence Ltd., 98 HFR, 90 –Daily Dow Jones Hedge Fund Strategy benchmark HFR Indices MSCI Hedge Invest Index S&P Hedge Fund indices

Issues with Hedge Fund Indices Concerns about index construction –Selection, Styles, Weighting, Rebalancing, Investability Alpha determination –How to measure of alpha Biases in Indexes –Persistence of volatility thru time –Survivorship bias, poor tracks exit the index –Stale price bias, caused by infrequent trading – Backfill bias, missing parts of return in simulated

Hedge Funds: Characteristics Investment Characteristics –Long-bias in return leads to less diversifier effect –Replication using stocks and option data is limited Only reflects certain strategies –New frontiers: Using stocks, bonds, commodities, etc as risk factors in hedge fund analysis, refer to Prof. Andrew Lo (MIT) Role as Diversifier –Issues to consider in the context of MVO: Persistence of performance, portfolio rebalancing, impact of highly non-normal return distributions

Decomposition of HF Returns “CAN HEDGE-FUND RETURNS BE REPLICATED?: THE LINEAR CASE” Jasmina Hasanhodzica and Andrew W. Lo, Journal of Investment Management, 5(2), 2007, pp 5 – 45

HF Performance Evaluation Questions –Return achieved? Rolling return: 1/12 * [R t + … + R t – 12 ] –Volatility including downside risk Downside deviation (DD): [1/12*∑{min(R t – R*, 0)} 2 ] 1/2 –What performance measure is suitable? Sharpe ratio: [Ret. – RF]/Std Dev. Sortino ratio: [Ret. – RF]/Downside Dev. Gain-to-loss ratio: [# Pos. / # Neg.]*[Up Ret./Dn Ret.] –Correlations –Skewness and kurtosis –Consistency

Managed Futures Types –Systematic trading strategies rule-based trend following –Discretionary trading strategies Based on portfolio managers’ judgments Benchmarks –CISDM CTA CTA$ dollar weighted index CTAEQ equal weighted index

Managed Futures: Characteristics Investment Characteristics –Zero-sum game; long-run return is risk-free rate –If hedgers pay a premium for liquidity, or arbitrage out inefficiencies Momentum strategies can have excess return and impart the positive skewness Options allow to trade on volatility patterns Role as Diversifier –Can add value to stock/bond/hedge funds Public commodity pools have had poor performance but private pools added value

Distressed Securities Types –Hedge fund or Private Equity fund –Asset types Public debt & equity of distress firms Orphan equity: shares of reorganized firm Bank debt or trade notes of distressed firms Benchmarks –Distressed securities hedge fund indexes CISDM, HFR, EACM –Altman-NYU Salomon Center Defaulted Public Bond and Bank Loan Index

Distressed Sect.: Characteristics Investment Characteristics –Negative skewness and large kurtosis Bad events happen more often than “normal” –Dependent on economic conditions –“Fallen Angel” phenomenon – almost like what is going on CDO market right now! Role as Diversifier –Only 5% of institutional funds invest in DS!

Distressed Securities Strategies Long-only Value Investing –High yield (Junk Bond) Investing –Orphan Equity Investing Distressed Debt Arbitrage –Buy distressed debt and short distressed equity Private Equity –Prepackaged bankruptcy (vulture funds) Event risk, liquidity risk, market risk, J-factor risk