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Open-end and Closed-end Funds
 Open-end and Closed-end funds are classes of investment
funds.
Study Session 18, Reading 66
Open-end Funds
 a type of mutual
fund that does not
have restrictions on the
amount of shares the
fund will issue
Closed-end Funds
 have a finite amount of
capital the fund manager will
invest. Shares are priced in
the secondary market where
they are traded (and can
trade at a premium or
discount to their net asset
value)
Calculating the Net Asset Value of
Investment Funds
 Net Asset Value (NAV) = Market value of the Fund
Portfolio amount ($) / Number of units
For example:
NAV = $100 / 10 (units) = $10 per unit
Study Session 18, Reading 66
Nature of Fees Charged by
Investment Companies
 Management fees are the total fees charged by investment
companies to its investors. (i.e. operating expenses,
administrative expenses and distribution fees)
 Expense Ratio = Operating Expenses/Average Asset Size (funds
under management)
Study Session 18, Reading 66
Open-end and Closed-end Funds
 Fees can be described as either front end loaded or back end
loaded.
Study Session 18, Reading 66
Front end loaded
 charged by investment
companies as sales
commissions at the time
of purchase or as fee for
arranging the
transaction.
Back end loaded
 charged by investment
companies to discourage
investors from switching
funds (i.e. exit fees)
Investment Strategies
 Equity investment strategies can be characterized as global,
index, sector, style or stable value strategies.
 If an equity investor takes a long position:
-in high P/E stocks, they may be adopting a growth
investment strategy
-low P/E stocks, they may be adopting a value strategy
Study Session 18, Reading 66
Investment Strategies
 Large capitalization stocks are less risky and less volatile than
small stocks, which have lower product diversification. Hence,
small cap stocks generate higher earnings than large cap
stocks.
 International funds invest in securities of foreign countries
whereas global funds may hold securities of both home and
foreign securities.
Study Session 18, Reading 66
Investment Strategies
 Sector specific investment funds concentrate on investing
in a particular industry.
 An index fund holds an identical portfolio the an
investment index (i.e. same stocks and weights)
 Stable value funds invest in short term debt instruments
with guaranteed principal and a fixed interest rate.
Study Session 18, Reading 66
Exchange Traded Funds
 an investment fund which can be bought/sold like
company shares on a stock market
 essentially track a specific index, sector/industry, fixed
income index etc.
Study Session 18, Reading 66
Exchange Traded Funds
 Global ETF invest in global securities
 In the US, ETF have adopted three different types of legal
structures:
 Managed Investment Companies
 Unit Investment Trusts
 Grantor Trusts
Study Session 18, Reading 66
Exchange Traded Funds
 If demand for an investment funds exceeds supply, authorized
participants generate a creation unit and relevant stocks are
deposited to the trustee according to the appropriate weights
required to track the index.
 To sell an ETF, an authorized participant will exchange a
redemption unit with the relevant fund.
Study Session 18, Reading 66
Traditional Mutual Funds vs
Closed-end Funds
Traditional Mutual Funds
 have an infinite possible
number of units which
can be created as
investors buy or sell
units in the fund.
*Also known as open end
funds
Closed-end Funds
 have a stable number of
units which fluctuate in
price according to demand
or supply of investment
units
Study Session 18, Reading 66
Exchange Traded Funds ─ Advantages
 provide diversification benefits to investors, with low transaction
costs.
 can be shorted and purchased with margin loans
 take futures and options positions over their index
 Unlike closed-end funds, ETFs do not trade at heavy discounts or
premium to NAV. If the value of the ETF varies from its NAV, an
investor can take advantage of an arbitrage opportunity.
Study Session 18, Reading 66
Exchange Traded Funds ─ Advantages
 In contrast to Mutual Funds:
 traded during trading hours (MF can only be traded once a day)
 provide investors with greater transparency as they publish
portfolio positions daily
 relatively cost effective
 capital gain tax is lower
 dividends are immediately reinvested
Study Session 18, Reading 66
ETF─ Disadvantages
 mainly holds large capitalization stocks
 attract longer term investors; intraday trading is not required
 For larger corporations, direct investment in an index can be a
perfect substitute for an ETF. Alternatively, an investor may
invest in an actively managed international fund which may
have a lower cost and lower taxes.
Study Session 18, Reading 66
Exchange Traded Funds ─ Risks
 market risk is the same as other managed portfolio that are
well diversified
 may carry asset class and sector risk
 trading risk – depth and liquidity fluctuates in secondary
markets
 tracking error risk – index value and NAV may differ as well
 derivatives risk – ETFs are exposed to credit risk and increased
leverage
 currency risk – for ETF invested in international indices
Study Session 18, Reading 66
Types of Exchange Traded Funds
 Domestic Market Index – track a stock market index of a
specific country
 Style – may vary, but can include small, mid and large market-
cap, value and growth etc.
 Sector – technology, telecommunications, media, insurance
etc.
 Foreign country or regions
 Fixed Income
 Commodity
 Actively Managed Funds
Study Session 18, Reading 66
Real Estate Investments
 the most common form of tangible asset investment
 Insurance companies and pension funds favour real estate as
an asset class.
 The 4 types of real estate investment are:
1) Clear and Free Equity
2) Leveraged Equity
3) Mortgages
4) Aggregation Vehicles
Study Session 18, Reading 66
Types of Real Estate Investments
1. Clear and Free Equity – direct purchase of property without a
mortgage
2. Leverage Equity–ownership rights are given to the investor
on the basis of the promise to return the property to the
lender if he fails to meet the terms of the loan
3. Mortgages– investor receives principal and interest
payments, in return for providing initial capital to the
purchaser of the property
Study Session 18, Reading 66
Types of Real Estate Investments
4. Aggregation Vehicles – accumulates investors and provides
them with easy access to real estate investment
─Common forms include:
 Real Estate Limited Partnerships (RELPs)
 Commingled Funds
 Real Estate Investment Trusts (REITs)
Study Session 18, Reading 66
Forms of Aggregation Vehicles
 RELP – allow investors to act as limited partners so that they
can invest in real estate projects, while outsourcing the
management rights of the property.
 Commingled fund –investors come together to invest in real
estate projects, which can be closed or open end funds.
Study Session 18, Reading 66
Forms of Aggregation Vehicles
 REITs
– closed-end investment companies that issue shares which
is trade on the stock market
– allows smaller investors the ability to buy real estate,
– traded on the stock market and may trade at a premium
or discount to the NAV of the portfolio
Study Session 18, Reading 66
Characteristics of
Real Estate Investments
 Property is immovable and indivisible
 Property can be compared with similar properties although it
can be difficult
 Market value is hard to assess, no international or local
platforms for this trade
 Management and transaction costs are higher
 Market is relatively inefficient because of information
deficiency.
Study Session 18, Reading 66
Real Estate Valuation
 Real estate valuation differs from other asset classes, given the
unique nature of real estate assets and its relative illiquidity
5 key approaches:
1. Cost Approach
2. Sales Comparison Approach
3. Hedonic Price Estimation
4. Income Approach
5. Discounted After Tax Cash Flow Approach
Study Session 18, Reading 66
Real Estate Valuation Approaches
 Cost Approach – Calculated as replacement cost (i.e.
estimated value of the land and then the cost of building)
 Sales Comparison Approach – A benchmark value is set for
similar properties and then a price is quoted on a property.
 Hedonic Price Estimation – Major characteristics can
determine the value of a property.
Study Session 18, Reading 66
Real Estate Valuation Approaches
 Income Approach – A perpetuity discount model is used for the
valuation of property, with the perpetuity cash flow discounted
at the required rate of return.
 Discounted After Tax Cash Flow Approach – Value of the
property is the discounted sum of the after tax cash flows that
the property is expected to derive.
Study Session 18, Reading 66
Real Estate Pricing Approaches
 Income Approach – the perpetuity discount model is used:
Appraisal Price = (NOI)/(Market Cap Rate)
 The market cap rate is derived from recent transactions and is
solved by finding the discount rate used to discount future
income to make it equal to the market value of the property.
Market Cap Rate = (Benchmark NOI)/(Benchmark transaction price)
Study Session 18, Reading 66
Income Approach
Given: NOI=$83,800 Depreciation=$18,700
Mortgage Payment=$59,404 Purchase Price=$700,000
NOI Growth Rate = 5% Marginal Income Tax Rate = 31%
To calculate after tax cash flow for year one:
$560,000 is 80% of $700,000 10% of $560,000=$56,000
Income after tax will be ($83,800 - $18,700 - $56,000) x (1 – 0.31) = $6,279
Principal Payment = Mortgage Payment – Interest Payment
$3,404= $59,404 - $56,000
Hence Cash Flow after tax for the 1st year = $6,279 + $ 18,700 - $3,404 = $ 21,575
Study Session 18, Reading 66
Real Estate Pricing Approaches
 The benchmark method can be based on a single transaction
or an average of recent transactions.
 The valuation derived from the growth dividend discount
model is equal to the income approach valuation if rental
growth rates are assumed to be constant.
Study Session 18, Reading 66
Private Equity
 Private equity is a private, unlisted investment
 Investors enter limited partnerships with limited liability and
hand over the management to the private equity business to
professional investors.
Study Session 18, Reading 66
Types of Private Equity Investment
 Venture Capital
─Investments in ventures from initial stage to the stage where
the company is able to sell its products. Eventually the private
equity shareholders exit.
Study Session 18, Reading 66
Types of Private Equity Investment
 Leverage Buyouts
─ Investors take over a targeted company by acquiring
majority control (buying 20– 40% of the company’s equity, and
borrowing the rest)
─ The companies are normally publicly traded but delisted,
making it a private company
─ Investors typically aim to sell out the company within a few
years, often via an IPO
Study Session 18, Reading 66
Types of Private Equity Investment
 Distressed Investing
─ Investors take a long position in debt/equity securities of
companies in distress.
─ Generally, they look for companies which are operationally
sound, and look to restructure/reorganise them.
Study Session 18, Reading 66
Stages of Venture Capital Investments
 Seed stage – funding given for a business idea
 Early stage – funding where the capital is given to the
company to start its operations
 Formative stage – funding includes seeding and early stages
Study Session 18, Reading 66
Stages of Venture Capital Investments
 Later-stage is before the investors raise capital via an IPO and
after manufacturing and sales have commenced.
 Second stage – funds needed for expansion
 Third stage – funds for major expansion
 Mezzanine (also known as bridge financing) is provided
for a company to prepare for going public
Study Session 18, Reading 66
Challenges of Investing in
Venture Capital
 Illiquidity - highly uncertain cash flows
 Long-term commitment is required
 Determining current market value is difficult
 Limited historic risk and return information
 Limited information
 Entrepreneurial mismatch
Study Session 18, Reading 66
Challenges of Investing in
Venture Capital
 Fund manager incentive mismatch
 Ignorance of competition
 Vintage cycle
 Extensive operational analysis needed
 Liquidation
Study Session 18, Reading 66
Performance Measurement Challenges
 Fund managers are unable to accurately price ongoing
projects, hence are unable to measure performance.
 Lack of benchmarks to compare performance.
 Lack of reliable long term performance data.
Study Session 18, Reading 66
Venture Capital Valuation
 In order to value a Venture Capital investment, an investor
needs to make assumptions regarding:
 Assessment of payout at the time of exiting the project
 Assessment of time it will take for the venture to become
successful
 Assessment of failure probability
Study Session 18, Reading 66
Venture Capital Valuation
For Example:
An investor wants to invest $1m and expects $16m return in 7 years
time. The project has a failure probability of 0.25 (1st year), 0.22 (2nd year) and
0.2 (3rd year till the 7th year)
Probability that the project will survive = (1 – 0.25) (1 – 0.22) (1 –0.20)5
= 0.192 or 19.2%
NPV of $16m project if it is a success is $4.02m
NPV of $16m project if it is a failure is -$1.00m
Expected NPV = (0.192)($4.02m) + (0.808)(-$1m) = -$36,160
Study Session 18, Reading 66
Hedge Funds
Objective of Hedge Funds
Originally hedge funds were created to allow investors used to
bet against the market. However, the evolution of hedge funds
has meant that the purpose and scope of these funds has
broadened significantly.
Study Session 18, Reading 66
Hedge Funds
Legal Structure of Hedge Funds
 setup as limited partnership or limited liability corporations
 hedge fund managers can take short/long positions in any
asset, using derivatives and leverage at its discretion
Study Session 18, Reading 66
Hedge Funds
Fee Structure of Hedge Funds
Hedge fund managers are paid a base management fee
depending on the asset size. Additionally, they receive an
incentive fee if returns exceed cost of capital.
Study Session 18, Reading 66
Fund of Funds Investing
Funds of Funds (FOF) created for the easy access of small and
institutional investors.
Benefits
 Diversification – exposure to a no. of hedge funds
 Access –exposure to hedge funds closed to new investors
 Expertise –expertise in finding good performing hedge funds
 Due diligence process – able to handle due diligence of hedge
funds
Study Session 18, Reading 66
Leveraging
 Hedge funds may use financial leverage to magnify returns but
it also magnifies losses.
 Managers can create leveraging while trading by:
 Shorting more equity that they are trading
 Brokerage accounts provide borrowing on their margin
accounts
 Financial instruments and derivatives
Study Session 18, Reading 66
Risks of Hedge Funds
 Liquidity Risk - in case of illiquidity in a market, hedge funds
using leverage can incur significant losses if positions move
against them
 Pricing Risk –margin calls can create major cash liquidity
problems
 Counterparty Credit Risk – can arise as hedge funds invest in
over the counter derivatives
Study Session 18, Reading 66
Risks of Hedge Funds
 Settlement Risk – exposed by counterparties on settlement
day
 Short Squeeze Risk – when the price of a stock that a hedge
fund has a short position in rises
 Financing Squeeze –when a hedge has to raise capital to meet
the commitments (i.e. borrowing capacity, margin calls, marking to
market of positions).
Study Session 18, Reading 66
Hedge Fund Indices
 Historical performance of hedge fund indices may overstate
actual returns from this asset class due to a series of biases.
 The most common biases include:
1. Self Selection Bias
2. Backfilling Bias
3. Survivorship Bias
Study Session 18, Reading 66
Biases Affecting Hedge Fund Indices
 Self-Selection Bias: Managers with a poor track record will not
have their past performance included in the database
 Backfilling Bias: Only hedge funds with good track record enter
the database.
 Survivorship Bias: Hedge fund data only includes data of funds
that have survived over the entire sample period
Study Session 18, Reading 66
Effect of Biases on Risk Measures
Biases also affect a funds risk measures as they:
 Smooth pricing of assets traded infrequently like private
equity or real estate
 Invest in strategies with characteristics like options
 Gaming fee structures
Study Session 18, Reading 66
Effect of Biases on Hedge Fund Indices
For example:
A hedge fund manager starts 5 new funds. After a couple of
years, three of the funds keep posting negative returns and
manager decides to close down the poor performing funds.
Following this, the manager submits the performance data of
the remaining two funds to a well known database of hedge
fund performance. Hence, only adding the best performing
funds to the database is misleading and a clear case of
survivorship bias. This overstates the attractiveness of hedge
fund investing.
Study Session 18, Reading 66
Effect of Survivorship Bias on
Hedge Fund Database
Only hedge funds that have survived over the entire
measurement period are included in the calculation of a hedge
fund index performance. Therefore, the returns exclude the
performance of funds which have ceased to exist over the
sample period. Hedge fund indices tend to overstate true fund
performance by excluding the worst performing funds.
Study Session 18, Reading 66
What are Closely Held Companies?
 Closed held companies are not frequently traded or listed on
the stock exchange.
 Inactively traded securities are companies that are illiquid,
have less information available, and low dispersion of owners.
Study Session 18, Reading 66
Legal Environment
 Closely held companies can be formed as Special Corporations
which have special tax advantages.
 Valuation of closely held companies and not actively traded
shares require proper knowledge of the law and the reasons
for undertaking the valuation in order to address the taxation
implications of a change in ownership.
Study Session 18, Reading 66
Valuation of Closely Held Companies
1. Cost Approach –valuation at the cost to replace the assets of the
company
2. Comparable Approach – a benchmark is made by choosing one or
the average of a few similar actively traded companies
3. Income approach –discounting future expected income streams.
4. Premium/Discount Approach - adjusting the valuation to account
for relative illiquidity, marketability, and level of control of the
shareholding
Study Session 18, Reading 66
Distressed Investing
 Investing in distress securities is a type of venture capital
investing and is considered a form of value investing.
 A company that has distressed securities either has already
filed or near to filing for bankruptcy. In US there are two types
of bankruptcy options:
 Protection of liquidation
 Protection of reorganization
Study Session 18, Reading 66
Distressed Investing: Benefits
 Distressed companies tend to trade at a low enterprise value
(EV) to EBITDA multiple. Therefore, there can be significant
returns to investors if the company is able to boost cash flows
following the restructure, as it may also result in an expansion
of the EV/EBITDA multiple.
Study Session 18, Reading 66
Analysing Distressed Securities
 Is the company in financial distress (high leverage) or are its
operations suffering significant?
 What will drive an improvement in the performance of the
business:
 Cost cutting
 Improvement in business cycle
 New management
 New strategy
Study Session 18, Reading 66
Distressed Security Investing &
Venture Capital Investing
 Distressed security investing shares some similar
characteristics to venture capital investing as they both have
low liquidity, requires a lot of time, and needs significant
investor attention.
Study Session 18, Reading 66
What are Commodities?
Types of Commodities
 Agricultural (canola, coca, coffee, corn, wheat , sugar, and etc)
 Energy (i.e. crude oil, gas oil, heating oil, natural gas and etc)
 Metals (gold, silver, copper and etc)
Study Session 18, Reading 66
Why Invest in Commodities?
 Passive investment – is made through futures contracts for risk
diversification purposes
 Active investment –commodity prices provide a hedge against
inflation and are linked to the real economic growth
Study Session 18, Reading 66
Why Invest in Commodities?
 Diversification
 Monitoring liquidity
 Volatility
 Quantitative risk management
 Budgeting of risk
 Leverage limits derivative hedging for managing currency risk
 Performance adjustment risk-wise
Study Session 18, Reading 66
Contango
 Occurs when commodity prices are high and volatile. However
the price of futures contract has a ceiling which it cannot
break because of a “carry trade”.
 future price > spot price
Study Session 18, Reading 66
Backwardation
 The exact opposite of Contango
 Future price < spot price
 Is a threat to producers of the commodity as it becomes a
business risk.
 Natural backwardation –a fall in price has a greater impact on
the few producers as compared to the consumers.
Study Session 18, Reading 66
Carry Trade
 limits the futures price of a commodity to a limit known as
‘fully carry’.
 In the case of Gold, the futures price would normally be
touching fully carry
 In cases like ‘Hogs’, which have finite lives, full carry do not
apply, hence the future prices can be higher than the fully
carry price
Study Session 18, Reading 66
Carry Trade
 When an investor buys a futures contract, it deposits money
known as collateral. The money deposited generates return
known as ‘collateral yield’.
 When a futures contract matures, it finishes and another
contract is bought that has a longer maturity, this trade is
known as ‘rolling the contract’.
Study Session 18, Reading 66
Sources of Returns when Investing
in Commodity Derivatives
1. Collateral yield – money deposited when entering into a
derivative position
2. Roll yield (‘convenience yield’) – the return when the
maturity of derivative is renewed for longer period of
time
3. Spot price return – fluctuations in the value of the
commodity
Study Session 18, Reading 67
Commodity Controversies
 Commodity prices may decline because of the introduction in
new technology or increase in supply.
 The demand of commodities that can be stored increases with
economic growth. There is an inverse relationship between a
currency’s purchasing power parity and commodity prices.
Study Session 18, Reading 67
Investing in Commodity Derivatives:
Roll yield and Rolling Costs
 Roll yield –has always existed in the past even in the situation
of backwardation
 Rolling Costs –If an investor chooses to roll over a contract at
the maturity of a futures contract, it comes at a cost of selling
the matured contract and buying the new one. Rollover costs
can be reduced via active roll maturity.
Study Session 18, Reading 67
Investing in Commodity Derivatives:
Return Premium Controversy
 geometric mean returns of the average commodity is almost
zero
 geometric mean of a commodity index has been strong.
Ave. Volatility of the Index < Ave. Volatility of the Components
This occurs because index funds require rebalancing after large
commodity price movements.
Study Session 18, Reading 67
Benefits of Adding
Commodities to a Portfolio
 its negative correlation with other asset classes is an attractive
feature for maximising diversification benefits
 provides natural inflation hedge, a feature beneficial in
adopting an inflation matching strategy
 Utility arbitrage - investors with diff. objectives to transfer
between themselves and maximise group investor utility
Study Session 18, Reading 67
Institutional Ownership
of Commodities
 Commodity markets are changing because of increased
interest in commodities from institutional investors.
 Institutions money is derailing the commodity market from its
fundamentals. However the divergences between price and
fundamental value will eventually revert over time.
Study Session 18, Reading 67
Why a Commodity Index
Strategy is Active
 Commodity index funds are active investments because of
high fund turnover. This is driven by a change in constituent
weights, a rolling methodology is implied, and cash collateral
positions are continuously reinvested as short term cash
equivalents.
Study Session 18, Reading 67

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L1 flash cards alternative investments (ss18)

  • 1. Open-end and Closed-end Funds  Open-end and Closed-end funds are classes of investment funds. Study Session 18, Reading 66 Open-end Funds  a type of mutual fund that does not have restrictions on the amount of shares the fund will issue Closed-end Funds  have a finite amount of capital the fund manager will invest. Shares are priced in the secondary market where they are traded (and can trade at a premium or discount to their net asset value)
  • 2. Calculating the Net Asset Value of Investment Funds  Net Asset Value (NAV) = Market value of the Fund Portfolio amount ($) / Number of units For example: NAV = $100 / 10 (units) = $10 per unit Study Session 18, Reading 66
  • 3. Nature of Fees Charged by Investment Companies  Management fees are the total fees charged by investment companies to its investors. (i.e. operating expenses, administrative expenses and distribution fees)  Expense Ratio = Operating Expenses/Average Asset Size (funds under management) Study Session 18, Reading 66
  • 4. Open-end and Closed-end Funds  Fees can be described as either front end loaded or back end loaded. Study Session 18, Reading 66 Front end loaded  charged by investment companies as sales commissions at the time of purchase or as fee for arranging the transaction. Back end loaded  charged by investment companies to discourage investors from switching funds (i.e. exit fees)
  • 5. Investment Strategies  Equity investment strategies can be characterized as global, index, sector, style or stable value strategies.  If an equity investor takes a long position: -in high P/E stocks, they may be adopting a growth investment strategy -low P/E stocks, they may be adopting a value strategy Study Session 18, Reading 66
  • 6. Investment Strategies  Large capitalization stocks are less risky and less volatile than small stocks, which have lower product diversification. Hence, small cap stocks generate higher earnings than large cap stocks.  International funds invest in securities of foreign countries whereas global funds may hold securities of both home and foreign securities. Study Session 18, Reading 66
  • 7. Investment Strategies  Sector specific investment funds concentrate on investing in a particular industry.  An index fund holds an identical portfolio the an investment index (i.e. same stocks and weights)  Stable value funds invest in short term debt instruments with guaranteed principal and a fixed interest rate. Study Session 18, Reading 66
  • 8. Exchange Traded Funds  an investment fund which can be bought/sold like company shares on a stock market  essentially track a specific index, sector/industry, fixed income index etc. Study Session 18, Reading 66
  • 9. Exchange Traded Funds  Global ETF invest in global securities  In the US, ETF have adopted three different types of legal structures:  Managed Investment Companies  Unit Investment Trusts  Grantor Trusts Study Session 18, Reading 66
  • 10. Exchange Traded Funds  If demand for an investment funds exceeds supply, authorized participants generate a creation unit and relevant stocks are deposited to the trustee according to the appropriate weights required to track the index.  To sell an ETF, an authorized participant will exchange a redemption unit with the relevant fund. Study Session 18, Reading 66
  • 11. Traditional Mutual Funds vs Closed-end Funds Traditional Mutual Funds  have an infinite possible number of units which can be created as investors buy or sell units in the fund. *Also known as open end funds Closed-end Funds  have a stable number of units which fluctuate in price according to demand or supply of investment units Study Session 18, Reading 66
  • 12. Exchange Traded Funds ─ Advantages  provide diversification benefits to investors, with low transaction costs.  can be shorted and purchased with margin loans  take futures and options positions over their index  Unlike closed-end funds, ETFs do not trade at heavy discounts or premium to NAV. If the value of the ETF varies from its NAV, an investor can take advantage of an arbitrage opportunity. Study Session 18, Reading 66
  • 13. Exchange Traded Funds ─ Advantages  In contrast to Mutual Funds:  traded during trading hours (MF can only be traded once a day)  provide investors with greater transparency as they publish portfolio positions daily  relatively cost effective  capital gain tax is lower  dividends are immediately reinvested Study Session 18, Reading 66
  • 14. ETF─ Disadvantages  mainly holds large capitalization stocks  attract longer term investors; intraday trading is not required  For larger corporations, direct investment in an index can be a perfect substitute for an ETF. Alternatively, an investor may invest in an actively managed international fund which may have a lower cost and lower taxes. Study Session 18, Reading 66
  • 15. Exchange Traded Funds ─ Risks  market risk is the same as other managed portfolio that are well diversified  may carry asset class and sector risk  trading risk – depth and liquidity fluctuates in secondary markets  tracking error risk – index value and NAV may differ as well  derivatives risk – ETFs are exposed to credit risk and increased leverage  currency risk – for ETF invested in international indices Study Session 18, Reading 66
  • 16. Types of Exchange Traded Funds  Domestic Market Index – track a stock market index of a specific country  Style – may vary, but can include small, mid and large market- cap, value and growth etc.  Sector – technology, telecommunications, media, insurance etc.  Foreign country or regions  Fixed Income  Commodity  Actively Managed Funds Study Session 18, Reading 66
  • 17. Real Estate Investments  the most common form of tangible asset investment  Insurance companies and pension funds favour real estate as an asset class.  The 4 types of real estate investment are: 1) Clear and Free Equity 2) Leveraged Equity 3) Mortgages 4) Aggregation Vehicles Study Session 18, Reading 66
  • 18. Types of Real Estate Investments 1. Clear and Free Equity – direct purchase of property without a mortgage 2. Leverage Equity–ownership rights are given to the investor on the basis of the promise to return the property to the lender if he fails to meet the terms of the loan 3. Mortgages– investor receives principal and interest payments, in return for providing initial capital to the purchaser of the property Study Session 18, Reading 66
  • 19. Types of Real Estate Investments 4. Aggregation Vehicles – accumulates investors and provides them with easy access to real estate investment ─Common forms include:  Real Estate Limited Partnerships (RELPs)  Commingled Funds  Real Estate Investment Trusts (REITs) Study Session 18, Reading 66
  • 20. Forms of Aggregation Vehicles  RELP – allow investors to act as limited partners so that they can invest in real estate projects, while outsourcing the management rights of the property.  Commingled fund –investors come together to invest in real estate projects, which can be closed or open end funds. Study Session 18, Reading 66
  • 21. Forms of Aggregation Vehicles  REITs – closed-end investment companies that issue shares which is trade on the stock market – allows smaller investors the ability to buy real estate, – traded on the stock market and may trade at a premium or discount to the NAV of the portfolio Study Session 18, Reading 66
  • 22. Characteristics of Real Estate Investments  Property is immovable and indivisible  Property can be compared with similar properties although it can be difficult  Market value is hard to assess, no international or local platforms for this trade  Management and transaction costs are higher  Market is relatively inefficient because of information deficiency. Study Session 18, Reading 66
  • 23. Real Estate Valuation  Real estate valuation differs from other asset classes, given the unique nature of real estate assets and its relative illiquidity 5 key approaches: 1. Cost Approach 2. Sales Comparison Approach 3. Hedonic Price Estimation 4. Income Approach 5. Discounted After Tax Cash Flow Approach Study Session 18, Reading 66
  • 24. Real Estate Valuation Approaches  Cost Approach – Calculated as replacement cost (i.e. estimated value of the land and then the cost of building)  Sales Comparison Approach – A benchmark value is set for similar properties and then a price is quoted on a property.  Hedonic Price Estimation – Major characteristics can determine the value of a property. Study Session 18, Reading 66
  • 25. Real Estate Valuation Approaches  Income Approach – A perpetuity discount model is used for the valuation of property, with the perpetuity cash flow discounted at the required rate of return.  Discounted After Tax Cash Flow Approach – Value of the property is the discounted sum of the after tax cash flows that the property is expected to derive. Study Session 18, Reading 66
  • 26. Real Estate Pricing Approaches  Income Approach – the perpetuity discount model is used: Appraisal Price = (NOI)/(Market Cap Rate)  The market cap rate is derived from recent transactions and is solved by finding the discount rate used to discount future income to make it equal to the market value of the property. Market Cap Rate = (Benchmark NOI)/(Benchmark transaction price) Study Session 18, Reading 66
  • 27. Income Approach Given: NOI=$83,800 Depreciation=$18,700 Mortgage Payment=$59,404 Purchase Price=$700,000 NOI Growth Rate = 5% Marginal Income Tax Rate = 31% To calculate after tax cash flow for year one: $560,000 is 80% of $700,000 10% of $560,000=$56,000 Income after tax will be ($83,800 - $18,700 - $56,000) x (1 – 0.31) = $6,279 Principal Payment = Mortgage Payment – Interest Payment $3,404= $59,404 - $56,000 Hence Cash Flow after tax for the 1st year = $6,279 + $ 18,700 - $3,404 = $ 21,575 Study Session 18, Reading 66
  • 28. Real Estate Pricing Approaches  The benchmark method can be based on a single transaction or an average of recent transactions.  The valuation derived from the growth dividend discount model is equal to the income approach valuation if rental growth rates are assumed to be constant. Study Session 18, Reading 66
  • 29. Private Equity  Private equity is a private, unlisted investment  Investors enter limited partnerships with limited liability and hand over the management to the private equity business to professional investors. Study Session 18, Reading 66
  • 30. Types of Private Equity Investment  Venture Capital ─Investments in ventures from initial stage to the stage where the company is able to sell its products. Eventually the private equity shareholders exit. Study Session 18, Reading 66
  • 31. Types of Private Equity Investment  Leverage Buyouts ─ Investors take over a targeted company by acquiring majority control (buying 20– 40% of the company’s equity, and borrowing the rest) ─ The companies are normally publicly traded but delisted, making it a private company ─ Investors typically aim to sell out the company within a few years, often via an IPO Study Session 18, Reading 66
  • 32. Types of Private Equity Investment  Distressed Investing ─ Investors take a long position in debt/equity securities of companies in distress. ─ Generally, they look for companies which are operationally sound, and look to restructure/reorganise them. Study Session 18, Reading 66
  • 33. Stages of Venture Capital Investments  Seed stage – funding given for a business idea  Early stage – funding where the capital is given to the company to start its operations  Formative stage – funding includes seeding and early stages Study Session 18, Reading 66
  • 34. Stages of Venture Capital Investments  Later-stage is before the investors raise capital via an IPO and after manufacturing and sales have commenced.  Second stage – funds needed for expansion  Third stage – funds for major expansion  Mezzanine (also known as bridge financing) is provided for a company to prepare for going public Study Session 18, Reading 66
  • 35. Challenges of Investing in Venture Capital  Illiquidity - highly uncertain cash flows  Long-term commitment is required  Determining current market value is difficult  Limited historic risk and return information  Limited information  Entrepreneurial mismatch Study Session 18, Reading 66
  • 36. Challenges of Investing in Venture Capital  Fund manager incentive mismatch  Ignorance of competition  Vintage cycle  Extensive operational analysis needed  Liquidation Study Session 18, Reading 66
  • 37. Performance Measurement Challenges  Fund managers are unable to accurately price ongoing projects, hence are unable to measure performance.  Lack of benchmarks to compare performance.  Lack of reliable long term performance data. Study Session 18, Reading 66
  • 38. Venture Capital Valuation  In order to value a Venture Capital investment, an investor needs to make assumptions regarding:  Assessment of payout at the time of exiting the project  Assessment of time it will take for the venture to become successful  Assessment of failure probability Study Session 18, Reading 66
  • 39. Venture Capital Valuation For Example: An investor wants to invest $1m and expects $16m return in 7 years time. The project has a failure probability of 0.25 (1st year), 0.22 (2nd year) and 0.2 (3rd year till the 7th year) Probability that the project will survive = (1 – 0.25) (1 – 0.22) (1 –0.20)5 = 0.192 or 19.2% NPV of $16m project if it is a success is $4.02m NPV of $16m project if it is a failure is -$1.00m Expected NPV = (0.192)($4.02m) + (0.808)(-$1m) = -$36,160 Study Session 18, Reading 66
  • 40. Hedge Funds Objective of Hedge Funds Originally hedge funds were created to allow investors used to bet against the market. However, the evolution of hedge funds has meant that the purpose and scope of these funds has broadened significantly. Study Session 18, Reading 66
  • 41. Hedge Funds Legal Structure of Hedge Funds  setup as limited partnership or limited liability corporations  hedge fund managers can take short/long positions in any asset, using derivatives and leverage at its discretion Study Session 18, Reading 66
  • 42. Hedge Funds Fee Structure of Hedge Funds Hedge fund managers are paid a base management fee depending on the asset size. Additionally, they receive an incentive fee if returns exceed cost of capital. Study Session 18, Reading 66
  • 43. Fund of Funds Investing Funds of Funds (FOF) created for the easy access of small and institutional investors. Benefits  Diversification – exposure to a no. of hedge funds  Access –exposure to hedge funds closed to new investors  Expertise –expertise in finding good performing hedge funds  Due diligence process – able to handle due diligence of hedge funds Study Session 18, Reading 66
  • 44. Leveraging  Hedge funds may use financial leverage to magnify returns but it also magnifies losses.  Managers can create leveraging while trading by:  Shorting more equity that they are trading  Brokerage accounts provide borrowing on their margin accounts  Financial instruments and derivatives Study Session 18, Reading 66
  • 45. Risks of Hedge Funds  Liquidity Risk - in case of illiquidity in a market, hedge funds using leverage can incur significant losses if positions move against them  Pricing Risk –margin calls can create major cash liquidity problems  Counterparty Credit Risk – can arise as hedge funds invest in over the counter derivatives Study Session 18, Reading 66
  • 46. Risks of Hedge Funds  Settlement Risk – exposed by counterparties on settlement day  Short Squeeze Risk – when the price of a stock that a hedge fund has a short position in rises  Financing Squeeze –when a hedge has to raise capital to meet the commitments (i.e. borrowing capacity, margin calls, marking to market of positions). Study Session 18, Reading 66
  • 47. Hedge Fund Indices  Historical performance of hedge fund indices may overstate actual returns from this asset class due to a series of biases.  The most common biases include: 1. Self Selection Bias 2. Backfilling Bias 3. Survivorship Bias Study Session 18, Reading 66
  • 48. Biases Affecting Hedge Fund Indices  Self-Selection Bias: Managers with a poor track record will not have their past performance included in the database  Backfilling Bias: Only hedge funds with good track record enter the database.  Survivorship Bias: Hedge fund data only includes data of funds that have survived over the entire sample period Study Session 18, Reading 66
  • 49. Effect of Biases on Risk Measures Biases also affect a funds risk measures as they:  Smooth pricing of assets traded infrequently like private equity or real estate  Invest in strategies with characteristics like options  Gaming fee structures Study Session 18, Reading 66
  • 50. Effect of Biases on Hedge Fund Indices For example: A hedge fund manager starts 5 new funds. After a couple of years, three of the funds keep posting negative returns and manager decides to close down the poor performing funds. Following this, the manager submits the performance data of the remaining two funds to a well known database of hedge fund performance. Hence, only adding the best performing funds to the database is misleading and a clear case of survivorship bias. This overstates the attractiveness of hedge fund investing. Study Session 18, Reading 66
  • 51. Effect of Survivorship Bias on Hedge Fund Database Only hedge funds that have survived over the entire measurement period are included in the calculation of a hedge fund index performance. Therefore, the returns exclude the performance of funds which have ceased to exist over the sample period. Hedge fund indices tend to overstate true fund performance by excluding the worst performing funds. Study Session 18, Reading 66
  • 52. What are Closely Held Companies?  Closed held companies are not frequently traded or listed on the stock exchange.  Inactively traded securities are companies that are illiquid, have less information available, and low dispersion of owners. Study Session 18, Reading 66
  • 53. Legal Environment  Closely held companies can be formed as Special Corporations which have special tax advantages.  Valuation of closely held companies and not actively traded shares require proper knowledge of the law and the reasons for undertaking the valuation in order to address the taxation implications of a change in ownership. Study Session 18, Reading 66
  • 54. Valuation of Closely Held Companies 1. Cost Approach –valuation at the cost to replace the assets of the company 2. Comparable Approach – a benchmark is made by choosing one or the average of a few similar actively traded companies 3. Income approach –discounting future expected income streams. 4. Premium/Discount Approach - adjusting the valuation to account for relative illiquidity, marketability, and level of control of the shareholding Study Session 18, Reading 66
  • 55. Distressed Investing  Investing in distress securities is a type of venture capital investing and is considered a form of value investing.  A company that has distressed securities either has already filed or near to filing for bankruptcy. In US there are two types of bankruptcy options:  Protection of liquidation  Protection of reorganization Study Session 18, Reading 66
  • 56. Distressed Investing: Benefits  Distressed companies tend to trade at a low enterprise value (EV) to EBITDA multiple. Therefore, there can be significant returns to investors if the company is able to boost cash flows following the restructure, as it may also result in an expansion of the EV/EBITDA multiple. Study Session 18, Reading 66
  • 57. Analysing Distressed Securities  Is the company in financial distress (high leverage) or are its operations suffering significant?  What will drive an improvement in the performance of the business:  Cost cutting  Improvement in business cycle  New management  New strategy Study Session 18, Reading 66
  • 58. Distressed Security Investing & Venture Capital Investing  Distressed security investing shares some similar characteristics to venture capital investing as they both have low liquidity, requires a lot of time, and needs significant investor attention. Study Session 18, Reading 66
  • 59. What are Commodities? Types of Commodities  Agricultural (canola, coca, coffee, corn, wheat , sugar, and etc)  Energy (i.e. crude oil, gas oil, heating oil, natural gas and etc)  Metals (gold, silver, copper and etc) Study Session 18, Reading 66
  • 60. Why Invest in Commodities?  Passive investment – is made through futures contracts for risk diversification purposes  Active investment –commodity prices provide a hedge against inflation and are linked to the real economic growth Study Session 18, Reading 66
  • 61. Why Invest in Commodities?  Diversification  Monitoring liquidity  Volatility  Quantitative risk management  Budgeting of risk  Leverage limits derivative hedging for managing currency risk  Performance adjustment risk-wise Study Session 18, Reading 66
  • 62. Contango  Occurs when commodity prices are high and volatile. However the price of futures contract has a ceiling which it cannot break because of a “carry trade”.  future price > spot price Study Session 18, Reading 66
  • 63. Backwardation  The exact opposite of Contango  Future price < spot price  Is a threat to producers of the commodity as it becomes a business risk.  Natural backwardation –a fall in price has a greater impact on the few producers as compared to the consumers. Study Session 18, Reading 66
  • 64. Carry Trade  limits the futures price of a commodity to a limit known as ‘fully carry’.  In the case of Gold, the futures price would normally be touching fully carry  In cases like ‘Hogs’, which have finite lives, full carry do not apply, hence the future prices can be higher than the fully carry price Study Session 18, Reading 66
  • 65. Carry Trade  When an investor buys a futures contract, it deposits money known as collateral. The money deposited generates return known as ‘collateral yield’.  When a futures contract matures, it finishes and another contract is bought that has a longer maturity, this trade is known as ‘rolling the contract’. Study Session 18, Reading 66
  • 66. Sources of Returns when Investing in Commodity Derivatives 1. Collateral yield – money deposited when entering into a derivative position 2. Roll yield (‘convenience yield’) – the return when the maturity of derivative is renewed for longer period of time 3. Spot price return – fluctuations in the value of the commodity Study Session 18, Reading 67
  • 67. Commodity Controversies  Commodity prices may decline because of the introduction in new technology or increase in supply.  The demand of commodities that can be stored increases with economic growth. There is an inverse relationship between a currency’s purchasing power parity and commodity prices. Study Session 18, Reading 67
  • 68. Investing in Commodity Derivatives: Roll yield and Rolling Costs  Roll yield –has always existed in the past even in the situation of backwardation  Rolling Costs –If an investor chooses to roll over a contract at the maturity of a futures contract, it comes at a cost of selling the matured contract and buying the new one. Rollover costs can be reduced via active roll maturity. Study Session 18, Reading 67
  • 69. Investing in Commodity Derivatives: Return Premium Controversy  geometric mean returns of the average commodity is almost zero  geometric mean of a commodity index has been strong. Ave. Volatility of the Index < Ave. Volatility of the Components This occurs because index funds require rebalancing after large commodity price movements. Study Session 18, Reading 67
  • 70. Benefits of Adding Commodities to a Portfolio  its negative correlation with other asset classes is an attractive feature for maximising diversification benefits  provides natural inflation hedge, a feature beneficial in adopting an inflation matching strategy  Utility arbitrage - investors with diff. objectives to transfer between themselves and maximise group investor utility Study Session 18, Reading 67
  • 71. Institutional Ownership of Commodities  Commodity markets are changing because of increased interest in commodities from institutional investors.  Institutions money is derailing the commodity market from its fundamentals. However the divergences between price and fundamental value will eventually revert over time. Study Session 18, Reading 67
  • 72. Why a Commodity Index Strategy is Active  Commodity index funds are active investments because of high fund turnover. This is driven by a change in constituent weights, a rolling methodology is implied, and cash collateral positions are continuously reinvested as short term cash equivalents. Study Session 18, Reading 67