The document discusses various types of investment funds including open-end funds, closed-end funds, exchange traded funds (ETFs), real estate investment funds, private equity funds, hedge funds, and fund of funds. It provides details on key characteristics such as legal structure, fees, investment strategies, risks, and performance measurement challenges for each type of fund. The document also covers topics such as net asset value calculation, types of fees for mutual funds, real estate valuation approaches, stages of private equity investments, and challenges of investing in venture capital.
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
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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)
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4. Open-end and Closed-end Funds
Fees can be described as either front end loaded or back end
loaded.
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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
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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.
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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.
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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.
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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
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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.
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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
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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.
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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
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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.
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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
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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
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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
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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
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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)
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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.
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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
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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.
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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
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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.
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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.
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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)
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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
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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.
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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.
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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.
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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
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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.
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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
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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
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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
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36. Challenges of Investing in
Venture Capital
Fund manager incentive mismatch
Ignorance of competition
Vintage cycle
Extensive operational analysis needed
Liquidation
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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.
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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
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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
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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.
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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
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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.
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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
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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
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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
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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).
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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
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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
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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
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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.
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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.
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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.
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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.
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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
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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
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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.
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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
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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.
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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)
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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
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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
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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
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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.
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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
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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’.
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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
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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.
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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.
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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.
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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
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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.
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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.
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