Alternative Investments

Alternative Investments: CAIA Level I, 4th Edition is the curriculum book for the Chartered Alternative Investment Analyst (CAIA) Level I professional examination. Covering the fundamentals of the alternative investment space, this book helps you build a foundation in alternative investment markets. You'll look closely at the different types of hedge fund strategies and the range of statistics used to define investment performance as you gain a deep familiarity with alternative investment terms and develop the computational ability to solve investment problems. From strategy characteristics to portfolio management strategies, this book contains the core material you will need to succeed on the CAIA Level I exam. This updated fourth edition tracks to the latest version of the exam and is accompanied by the following ancillaries: a workbook, study guide, learning objectives, and an ethics handbook.

Preface xxxiii

Acknowledgments xxxvii

About the Authors xli

Part 1 Introduction to Alternative Investments

Chapter 1 What is an Alternative Investment? 3

1.1 Alternative Investments by Exclusion 3

1.2 Alternative Investments by Inclusion 4

1.3 The Blurred Lines between Traditional and Alternative Investments 8

1.4 A History of Alternative Investing: The U.S. Case 10

1.5 Investments are Distinguished by Return Characteristics 11

1.6 Investments are Distinguished by Methods of Analysis 14

1.7 Eight Other Characteristics that Distinguish Alternative and Traditional Investments 16

1.8 Five Goals of Alternative Investing 18

1.9 Two Pillars of Alternative Investment Management 20

1.10 Overview of This Book 22

Review Questions 23

Chapter 2 The Environment of Alternative Investments 25

2.1 The Participants 25

2.2 Alternative Investment Structures 33

2.3 Key Features of Fund Structures 36

2.4 Financial Markets 40

2.5 Regulatory Environment 42

2.6 Liquid Alternative Investments 43

2.7 Taxation 47

2.8 Short Selling 49

Review Questions 52

Notes 53

Chapter 3 Quantitative Foundations 55

3.1 Return and Rate Mathematics 55

3.2 Returns Based on Notional Principal 57

3.3 Internal Rate of Return 60

3.4 Problems with Internal Rate of Return 64

3.5 Other Performance Measures 73

3.6 Illiquidity, Accounting Conservatism, IRR, and the J-Curve 75

3.7 Distribution of Cash Waterfall 77

Review Questions 85

Note 86

Chapter 4 Statistical Foundations 87

4.1 Return Distributions 87

4.2 Moments of the Distribution: Mean, Variance, Skewness, and Kurtosis 90

4.3 Covariance, Correlation, Beta, and Autocorrelation 94

4.4 Interpreting Standard Deviation and Variance 104

4.5 Testing for Normality 111

4.6 Time-Series Return Volatility Models 114

Review Questions 116

Chapter 5 Foundations of Financial Economics 117

5.1 Informational Market Efficiency 117

5.2 The Time Value of Money, Prices, and Rates 122

5.3 The Three Primary Theories of the Term Structure of Interest Rates 127

5.4 Forward Interest Rates 129

5.5 Arbitrage-Free Models 131

5.6 Binomial Tree Models 134

5.7 Single-Factor Default–Free Bond Models 137

5.8 Single-Factor Equity Pricing Models 143

Review Questions 148

Note 149

Chapter 6 Derivatives and Risk-Neutral Valuation 151

6.1 Foundations of Forward Contracts 151

6.2 Forward Contracts on Rates 155

6.3 Forward Contracts on Equities 157

6.4 Forward Contracts on Assets with Benefits and Costs of Carry 165

6.5 Forward Contracts Versus Futures Contracts 171

6.6 Managing Long-Term Futures Exposures 178

6.7 Option Exposures 180

6.8 Option Pricing Models 186

6.9 Option Sensitivities 188

Review Questions 190

Notes 191

Chapter 7 Measures of Risk and Performance 193

7.1 Measures of Risk 193

7.2 Estimating Value at Risk (VaR) 198

7.3 Benchmarking and Performance Attribution 203

7.4 Ratio-Based Performance Measures 204

7.5 Risk-Adjusted Return Measures 210

Review Questions 214

Notes 214

Chapter 8 Alpha, Beta, and Hypothesis Testing 215

8.1 Overview of Beta and Alpha 215

8.2 Ex Ante Versus Ex Post Alpha 217

8.3 Single-Factor Models and Regression 220

8.4 Inferring Ex Ante Alpha From Ex Post Alpha 225

8.5 Return Attribution, Alpha, and Beta 226

8.6 Ex Ante Alpha Estimation and Return Persistence 230

8.7 Return Drivers 231

8.8 Using Statistical Methods to Locate Alpha 234

8.9 Sampling and Testing Problems 239

8.10 Statistical Issues in Analyzing Alpha and Beta 242

Review Questions 246

Notes 247

Part 2 Real Assets

Chapter 9 Natural Resources and Land 251

9.1 Natural Resources Other Than Land 251

9.2 Land 256

9.3 Timber and Timberland 261

9.4 Farmland 263

9.5 Valuation and Volatility of Real Assets 268

9.6 Pricing and Historic Data Analysis 272

9.7 Contagion, Price Indices, and Biases 275

9.8 Key Observations Regarding Historical Returns of Timberland 278

9.9 Key Observations Regarding Historical Returns of Farmland 278

Review Questions 279

Notes 279

Chapter 10 Commodities 281

10.1 Investing in Commodities Without Futures 281

10.2 The Term Structure of Forward Prices on Commodities 288

10.3 Rolling of Forward and Futures Contracts 296

10.4 Normal Backwardation and Normal Contango 302

10.5 Commodity Exposure and Diversification 307

10.6 Expected Returns on Commodities 310

10.7 Commodity Futures Indices 312

10.8 Commodity Risk Attributes 314

10.9 Observations Based on Historical Returns 318

Review Questions 318

Notes 318

Chapter 11 Other Real Assets 319

11.1 Commodity Producers 319

11.2 Liquid Alternative Real Assets 322

11.3 Infrastructure 325

11.4 Intellectual Property Overview 336

11.5 Cash Flows of Intellectual Property 341

11.6 Visual Works of Art and Historical Performance Data 344

11.7 R&D and Patents as Unbundled Intellectual Property 346

11.8 Intellectual Property Conclusions 349

Review Questions 350

Notes 350

References 350

Chapter 12 Real Estate Assets and Debt 353

12.1 Categories of Real Estate 353

12.2 Advantages, Disadvantages, and Styles of Real Estate Investments 355

12.3 Real Estate Style Boxes 361

12.4 Residential Mortgages 363

12.5 Commercial Mortgages 372

12.6 Mortgage-Backed Securities Market 375

12.7 Liquid Alternatives: Real Estate Investment Trusts 380

12.8 Key Observations Regarding Historical Returns of Mortgage REITs 382

Review Questions 384

Notes 384

Chapter 13 Real Estate Equity 385

13.1 Real Estate Development 385

13.2 Commercial Real Estate Valuation 389

13.3 Details of the Income Approach to Real Estate Valuation 397

13.4 Illustration of the Income Method of Real Estate Valuation 402

13.5 Alternative Real Estate Investment Vehicles 403

13.6 Equity REIT Returns 409

13.7 Key Observations Regarding Historical Risks and Returns of Equity REITs 410

Review Questions 412

Part 3 Hedge Funds

Chapter 14 Structure of the Hedge Fund Industry 415

14.1 Distinguishing Hedge Funds 415

14.2 Hedge Fund Fees 419

14.3 Hedge Fund Classification 431

14.4 Hedge Fund Returns and Asset Allocation 433

14.5 Evaluating a Hedge Fund Investment Program 438

14.6 Three Research Studies on Whether Hedge Funds Adversely Affect the Financial Markets 441

14.7 Hedge Fund Indices 442

14.8 Conclusion 451

Review Questions 451

Notes 451

Chapter 15 Macro and Managed Futures Funds 453

15.1 Macro and Managed Futures Strategies 453

15.2 Global Macro 455

15.3 Managed Futures 459

15.4 Systematic Trading 464

15.5 Four Core Dimensions of Managed Futures Investment Strategies 476

15.6 Systematic Futures Portfolio Construction 479

15.7 Eight Core Benefits of Managed Futures for Investors 483

15.8 Evidence on Managed Futures Returns 485

15.9 Benefits of Managed Futures Funds 493

15.10 Key Observations Regarding Historical Returns of Macro and Systematic Diversified Funds 499

Review Questions 499

Notes 499

Chapter 16 Event-Driven Hedge Funds 501

16.1 The Sources of Most Event Strategy Returns 501

16.2 Activist Investing 505

16.3 Merger Arbitrage 517

16.4 Distressed Securities Funds 524

16.5 Event-Driven Multistrategy Funds 532

Review Questions 534

Notes 534

Chapter 17 Relative Value Hedge Funds 535

17.1 Overview of Relative Value Strategies 535

17.2 Convertible Bond Arbitrage 536

17.3 Volatility Arbitrage 551

17.4 Fixed-Income Arbitrage 565

17.5 Relative Value Multistrategy Funds 575

Review Questions 578

Notes 578

Chapter 18 Equity Hedge Funds 579

18.1 Commonalities of Equity Hedge Funds 579

18.2 Sources of Return 580

18.3 Market Anomalies 584

18.4 Implementing Anomaly Strategies 590

18.5 The Three Equity Strategies 594

18.6 Equity Hedge Fund Risks 605

Review Questions 605

Notes 606

Chapter 19 Funds of Hedge Funds 607

19.1 Overview of Funds of Hedge Funds 607

19.2 Investing in Multistrategy Funds 616

19.3 Investing in Funds of Hedge Funds 619

19.4 Investing in Portfolios of Single Hedge Funds 622

19.5 Multialternatives and Other Hedge Fund Liquid Alternatives 624

19.6 Key Observations Regarding Historical Returns of Funds of Funds 628

Review Questions 631

Notes 631

Part 4 Private Securities

Chapter 20 Private Equity Assets 635

20.1 Introduction to Private Equity Terms and Background 635

20.2 Overview of Three Forms of Pre-IPO Private Equity Investing 637

20.3 Venture Capital 639

20.4 Venture Capital as a Compound Option 647

20.5 Growth Equity 648

20.6 Buyouts and Leveraged Buyouts 651

20.7 Buyouts of Private Companies 653

20.8 Leveraged Buyouts (LBOs) 655

20.9 Merchant Banking 663

20.10 Dynamics of Private Equity Opportunities 663

Review Questions 665

Notes 666

Chapter 21 Private Equity Funds 667

21.1 Overview of Private Equity Funds 667

21.2 Private Equity Funds as Intermediaries 671

21.3 The LP and GP Relationship Life Cycle 677

21.4 Private Equity Fund Fees and Terms 680

21.5 Key Determinants of Venture Capital Fund Risks and Returns 687

21.6 Roles and Three Key Distinctions of Venture Capital and Buyout Managers 689

21.7 Leveraged Buyout Funds 689

21.8 Private Equity Liquid Alternatives 693

21.9 Private Equity Funds of Funds 698

21.10 Private Investments in Public Equity 699

21.11 Private Equity Secondary Markets and Structures 703

Review Questions 706

Notes 707

Chapter 22 Private Credit and Distressed Debt 709

22.1 Types of Fund Private Credit Vehicles 709

22.2 Fixed-Income Analysis 711

22.3 Credit Risk Analysis and the Bankruptcy Process 715

22.4 Leveraged Loans 725

22.5 Direct Lending 727

22.6 Mezzanine Debt 728

22.7 Distressed Debt 737

22.8 Private Credit Performance and Diversification 743

Review Questions 744

Note 744

References 745

Part 5 Structured Products

Chapter 23 Introduction to Structuring 749

23.1 Overview of Financial Structuring 749

23.2 Major Types of Structuring 750

23.3 The Primary Economic Role of Structuring 751

23.4 Collateralized Mortgage Obligations 753

23.5 Structural Model Approach to Credit Risk 761

23.6 Interest Rate Options 766

23.7 Introduction to Collateralized Debt Obligations 768

Review Questions 773

Note 773

Chapter 24 Credit Risk and Credit Derivatives 775

24.1 An Overview of Credit Risk 775

24.2 Reduced-Form Modeling of Credit Risk 776

24.3 Credit Derivatives Markets 783

24.4 Interest Rate Swaps 786

24.5 Credit Default Swaps 793

24.6 Other Credit Derivatives 801

24.7 CDS Index Products 804

24.8 Five Key Risks of Credit Derivatives 805

Review Questions 807

Notes 807

Chapter 25 CDO Structuring of Credit Risk 809

25.1 Overview of CDO Variations 809

25.2 Balance Sheet CDOs and Arbitrage CDOs 812

25.3 Mechanics of and Motivations for An Arbitrage CDO 814

25.4 Cash-Funded CDOs Versus Synthetic CDOs 816

25.5 Cash Flow CDOs Versus Market Value CDOs 820

25.6 Credit Enhancements 821

25.7 Other Types of CDOs 823

25.8 Risks of CDOs 824

Review Questions 829

Chapter 26 Equity-Linked Structured Products 831

26.1 Structured Products and Six Types of Wrappers 831

26.2 Four Potential Tax Effects of Wrappers 832

26.3 Structured Products with Exotic Option Features 835

26.4 Popular Structured Product Types 843

26.5 The EUSIPA Classification 844

26.6 Global Structured Product Cases 848

26.7 Structured Product Valuation 850

26.8 Motivations of Structured Products 854

Review Questions 855

Notes 856

Index 857

DONALD R. CHAMBERS, PhD, CAIA, is Associate Director of Programs at the CAIA Association, Chief Investment Officer of Biltmore Capital Advisors, and Emeritus Professor at Lafayette College in Easton, Pennsylvania. Dr. Chambers previously served as Director of Alternative Investments at Karpus Investment Management. He is a member of the editorial board of the Journal of Alternative Investments.

MARK J. P. ANSON, PhD, CAIA, CFA, CPA, JD, is Chief Investment Officer for Commonfund. Prior to joining Commonfund, he was the President and Chief Investment Officer of the Bass Family Office–winner of the Family Office of the Year award for 2014-2015. Dr. Anson previously served as President and Executive Director of Investment Services at Nuveen Investments Inc., Chief Executive Officer of both the British Telecom Pension Scheme and its wholly owned asset management company in London, Hermes Pension Management Limited, and Chief Investment Officer at California Public Employees' Retirement System. He has published over 100 research articles in professional journals, has won two Best Paper Awards, is the author of six financial textbooks, and sits on the editorial boards of several financial journals.

KEITH H. BLACK, PhD, CFA, CAIA, FDP is a managing director at the CAIA Association overseeing content strategy. He was previously an associate at Ennis Knupp and prior, an assistant professor at Illinois Institute of Technology. He is a member of the editorial board of the Journal of Alternative Investments.

HOSSEIN B. KAZEMI, PhD, CFA, is co-founder of and the Senior Advisor for the CAIA Association. Dr. Kazemi is the Michael and Cheryl Philipp Distinguished Professor of Finance at Isenberg School of Management, the University of Massachusetts Amherst, the Director of the Center for International Securities and Derivatives Markets, and editor of the Journal of Alternative Investments and Alternative Investment Analyst Review.

Success in the rapidly-evolving area of alternative investments depends on a firm understanding of the concepts, tools, and practices associated with it, as well as an unwavering dedication to professionalism. Alternative Investments: CAIA Level I, Fourth Edition provides a comprehensive introduction to institutional-quality alternative investments and has been designed to serve as a resource for professionals, a textbook for university courses, and as the primary component for Level I of the Charter Program of the Chartered Alternative Investment Analyst (CAIA) Association.

CAIA Association's Charter Program addresses the essential needs for professionals entering or advancing in the field of alternative investments. The CAIA Charter is the premier educational designation uniquely tailored to individuals specializing in institutional-quality alternative investments. Covering real assets, hedge funds and managed futures, private equity and private credit, as well as structured products and professional standards and ethics, the CAIA Charter demonstrates one's commitment to professionalism and command of the unique elements of these asset classes.

The CAIA Program is comprised of a two-tier exam process (Level I and Level II) through which Candidates may earn the CAIA Charter. The Level I exam assesses understanding of various alternative classes and knowledge of the tools and techniques used to evaluate the risk-return attributes of each one.

Written under the direction of the CAIA Association, with insights from many practicing and eminent professionals in this field, Alternative Investments: CAIA Level I best reflects the most current practices in the arena. It contains material on alternative investments that Level I Candidates need to know as they prepare for the exam. With coverage of everything from the characteristics of various strategies within each alternative asset class to portfolio management concepts central to alternative investments, the information found here will help build a solid foundation of knowledge about alternative investments markets.

This comprehensive resource:

• Uses investment analytics to examine each alternative asset class.
• Examines quantitative techniques used by investment professionals.
• Addresses the unique attributes associated with the alternative investment space.
• Is supplemented by study materials available at www.caia.org.

Since its inception in 2002, the CAIA Program's diverse curriculum has benefited a wide array of professionals—from institutional investors, investment advisers, alternative investment fund managers, and administrators, to accountants, lawyers, and academics.

The CAIA Association is a global professional body dedicated to creating greater alignment, transparency, and education for all investors, with a specific emphasis on alternative investments. A Member-driven organization representing professionals in more than 95 countries, CAIA advocates for the highest ethical standards and provides authoritative, unbiased insight on a broad range of investment strategies and industry issues, key among them being efforts to bring greater diversification to portfolio construction decisions to achieve better long-term investor outcomes.

Alternative Investments: CAIA Level I The official reading for the CAIA Level I exam

"As the array of offerings continues to grow in the world of alternative investments, many asset classes have morphed more into industries, accompanied by a widening breadth of risk profiles and performance dispersion. Value will accrue to the astute and patient investor, and the CAIA Level I curriculum is an outstanding source for needed education." —Elena Manola-Bonthond, PhD, CAIA, Chief Investment Officer, CERN Pension Fund

"We have seen extraordinary interest and growth in alternative risk premia over the last decade. Investors continue to either seek better risk-adjusted returns through a widening set of uncorrelated offerings, or to access an asset class or strategy that is expected to produce higher absolute returns in the current low-yield environment. Regardless of motivation, financial education has never been more important, and the CAIA Association Level I textbook is an essential read for all investors." —Valerie Sill, CFA, CAIA, President and Chief Executive Officer, Dupont Capital Management

"While the first hedge fund may have been formed 80 years ago, wider institutional adoption of these and other alternative investments has mainly been a feature of the most recent 20 years. The CAIA Association and their important educational mandate is ever more relevant in this Fourth Edition text. It is essential foundational reading for investment professionals who wish to succeed in today's complex world." —David George, CFA, CAIA, Deputy Chief Investment Officer, Public Markets, Future Fund Management Agency

Seasoned professionals looking to explore new areas within the alternative investment arena, as well as new industry participants seeking to establish a solid understanding of alternative investments, will find that Alternative Investments: CAIA Level I is the best way to achieve these goals, and the smartest way to prepare for the CAIA Level I exam.