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P1: TIX/XYZ P2: ABCJWBT670-fm JWBT670-CAIA February 29, 2012 21:54 Printer: Courier Westford


CAIALevel I


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CAIALevel I

An Introduction to Core Topicsin Alternative Investments

Second Edition

MARK J. P. ANSONwith

DONALD R. CHAMBERSKEITH H. BLACK

HOSSEIN KAZEMI

John Wiley & Sons, Inc.


Copyright c© 2009, 2012 by The CAIA Association. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Anson, Mark Jonathan Paul.CAIA level I : an introduction to core topics in alternative investments / Mark J. P. Anson with

Donald R. Chambers, Keith H. Black, and Hossein Kazemi – Second edition.pages cm. – (Wiley finance series)

Includes index.ISBN 978-1-118-25096-9 (cloth); ISBN 978-1-118-28299-1 (ebk);ISBN 978-1-118-28445-2 (ebk); ISBN 978-1-118-28565-7 (ebk)

1. Investments. 2. Securities. 3. Portfolio management. I. CAIA Association. II. Title.III. Title: CAIA level one. IV. Title: CAIA level 1.

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2011047548

Printed in the United States of America

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Contents

Preface xiii

Acknowledgments xvii

About the Authors xxi

PART ONEIntroduction to Alternative Investments 1

CHAPTER 1What Is an Alternative Investment? 31.1 Alternative Investments by Exclusion 31.2 Alternative Investments by Inclusion 41.3 Structures among Alternative Investments 81.4 Investments Are Distinguished by Return Characteristics 121.5 Investments Are Distinguished by Methods of Analysis 141.6 Goals of Alternative Investing 171.7 Overview of This Book 19

CHAPTER 2The Environment of Alternative Investments 212.1 The Participants 212.2 Financial Markets 282.3 Regulations 302.4 Taxation 38

CHAPTER 3Statistical Foundations 413.1 Frequency and Probability Distributions 413.2 Compounding Multiple Time Period Returns 443.3 Return Distributions and Autocorrelation 483.4 Moments of the Distribution: Mean, Variance, Skewness,

and Kurtosis 503.5 Computing Sample Statistics 543.6 More on Standard Deviation and Variance 593.7 Testing for Normality 643.8 Other Measures of Risk 66

v


vi CONTENTS

3.9 Estimating Value at Risk (VaR) 703.10 Time Series Return Volatility Models 753.11 Conclusion 77

CHAPTER 4Risk, Return, and Benchmarking 794.1 Benchmarking 794.2 Asset Pricing Models 824.3 Three Methods of Models 824.4 Cross-Sectional versus Time-Series Models 854.5 Single-Factor and Ex Ante Asset Pricing 874.6 Empirical Analyses with the CAPM 904.7 Multifactor Models 964.8 Alternative Asset Benchmarking 1034.9 Conclusion 107

CHAPTER 5Correlation, Alternative Returns, and Performance Measurement 1095.1 Correlation 1095.2 Internal Rate of Return 1185.3 Problems with IRR 1225.4 Returns Based on Notional Principal 1295.5 Distribution of Cash Waterfall 1325.6 Performance Measures 139

CHAPTER 6Alpha and Beta 1476.1 Overview of Beta and Alpha 1476.2 Ex Ante versus Ex Post Alpha 1496.3 Inferring Ex Ante Alpha from Ex Post Alpha 1556.4 Return Attribution 1586.5 Ex Ante Alpha Estimation and Persistence 1636.6 Return Drivers 1646.7 Summary of Alpha and Beta Analysis 168

CHAPTER 7Hypothesis Testing in Alternative Investments 1697.1 Four Steps of Hypothesis Testing 1707.2 A Test Assuming Normality 1737.3 Tests with Inferential Statistics 1767.4 Sampling and Testing Problems 1817.5 Cumulative Returns and Performance 1857.6 Statistical Issues in Analyzing Alpha and Beta 1897.7 Summary of Alpha and Beta Estimation 1967.8 Conclusion 198


Contents vii

PART TWOReal Assets 201

CHAPTER 8Land, Infrastructure, and Intangible Real Assets 2038.1 Land 2038.2 Timber and Timberland 2088.3 Farmland 2108.4 Infrastructure 2148.5 Intellectual Property 2208.6 Valuation and Volatility 2248.7 Historical Risks and Returns 228

CHAPTER 9Real Estate Fixed-Income Investments 2339.1 Residential Mortgages 2339.2 Commercial Mortgages 2419.3 Mortgage-Backed Securities Market 2449.4 Collateralized Mortgage Obligations 2499.5 Real Estate Investment Trusts 2559.6 Risks and Returns of Mortgage REITs 256

CHAPTER 10Real Estate Equity Investments 26110.1 Real Estate Development 26110.2 Valuation and Risks of Real Estate Equity 26410.3 Alternative Real Estate Investment Vehicles 27210.4 Real Estate and Depreciation 27810.5 Real Estate Equity Risks and Returns 28310.6 Risks and Returns of Equity REITs 288

PART THREEHedge Funds 293

CHAPTER 11Introduction to Hedge Funds 29511.1 Distinguishing Hedge Funds 29511.2 Hedge Fund Types 30211.3 Hedge Fund Fees 30411.4 Conclusion 315

CHAPTER 12Hedge Fund Returns and Asset Allocation 31712.1 Describing the Hedge Fund Universe 31712.2 Mean, Variance, Skewness, and Kurtosis of Strategies 31912.3 Categorizing Hedge Fund Strategies 32112.4 Should Hedge Funds Be Part of an Investment Program? 328


viii CONTENTS

12.5 Do Hedge Funds Undermine the Financial Markets? 33312.6 Hedge Fund Indices 33512.7 Conclusion 344

CHAPTER 13Macro and Managed Futures Funds 34513.1 Major Distinctions between Strategies 34513.2 Global Macro 34713.3 Returns of Macro Investing 35113.4 Managed Futures 35413.5 Systematic Trading 35713.6 Systematic Trading Styles 35913.7 Prior Empirical Research 36913.8 Conclusion 37613.9 Analysis of Historical Returns Conclusion 376

CHAPTER 14Event-Driven Hedge Funds 38114.1 The Sources of Most Event Strategy Returns 38114.2 Activist Investing 38414.3 Merger Arbitrage 39714.4 Distressed Securities Funds 40514.5 Event-Driven Multistrategy Funds 412

CHAPTER 15Relative Value Hedge Funds 41715.1 Convertible Bond Arbitrage 41815.2 Volatility Arbitrage 43315.3 Fixed-Income Arbitrage 44715.4 Relative Value Multistrategy Funds 459

CHAPTER 16Equity Hedge Funds 46116.1 Sources of Return 46216.2 Market Anomalies 46616.3 The Fundamental Law of Active Management 47216.4 Implementing Anomaly Strategies 47516.5 The Three Equity Strategies 48016.6 Conclusion 493

CHAPTER 17Funds of Hedge Funds 49517.1 Benefits and Costs of Diversification 49517.2 Investing in Multistrategy Funds 50217.3 Investing in Funds of Hedge Funds 50517.4 Fund of Funds Historical Returns 50817.5 Conclusion 520


Contents ix

PART FOURCommodities 523

CHAPTER 18Commodity Futures Pricing 52518.1 Forward and Futures Contracts 52518.2 Rolling Contracts 53018.3 The Term Structure of Forward Prices 53118.4 Backwardation and Contango 54218.5 Returns on Futures Contracts 545

CHAPTER 19Commodities: Applications and Evidence 55119.1 Commodity Investing for Diversification 55119.2 Commodity Investing for Return Enhancement 55519.3 Investing in Commodities without Futures 55719.4 Commodity Exposure through Futures Contracts 56219.5 Three Fallacies of Roll Return 56819.6 Commodity Futures Indices 57019.7 Commodity Risks and Returns 57219.8 Historical Risks and Returns 574

PART FIVEPrivate Equity 579

CHAPTER 20Introduction to Private Equity 58120.1 Private Equity Terminology and Background 58120.2 Private Equity as Equity Securities 58420.3 Private Equity as Debt Securities 58720.4 Trends and Innovations in Private Equity 592

CHAPTER 21Equity Types of Private Equity 59921.1 Venture Capital versus LBOs 59921.2 The Underlying Businesses of Venture Capital 60021.3 Venture Capital Funds 60121.4 Venture Capital Risks and Returns 60921.5 Leveraged Buyouts (LBOs) 61321.6 Leveraged Buyout Risks and Returns 623

CHAPTER 22Debt Types of Private Equity 62522.1 Mezzanine Debt 62522.2 Distressed Debt 63222.3 Risks of Distressed Debt Investing 637


x CONTENTS

PART SIXStructured Products 639

CHAPTER 23Credit Risk and the Structuring of Cash Flows 64123.1 An Overview of Credit Risk 64123.2 Modeling Credit Risk 64423.3 Structural Model Approach to Credit Risk 64623.4 Reduced-Form Model Approach to Credit Risk 65523.5 Structuring Using Collateralized Debt Obligations 66323.6 Conclusion 666

CHAPTER 24Credit Derivatives 66724.1 Credit Derivative Markets 66724.2 Credit Default Swaps 66924.3 Other Credit Derivatives 67824.4 Risks of Credit Derivatives 68024.5 Conclusion 683

CHAPTER 25Collateralized Debt Obligations 68525.1 Introduction to Collateralized Debt Obligations 68525.2 Balance Sheet CDOs versus Arbitrage CDOs 68825.3 Cash-Funded CDOs versus Synthetic CDOs 69225.4 Cash Flow CDOs versus Market Value CDOs 69525.5 Credit Risk and Enhancements 69625.6 New Developments in CDOs 69925.7 Risks of CDOs 703

PART SEVENRisk Management and Portfolio Management 709

CHAPTER 26Lessons from Hedge Fund Failures 71126.1 Problems Driven by Market Losses 71126.2 Failures Driven by Fraud 72126.3 Conclusion 727

CHAPTER 27Risk Analysis 72927.1 Investment Strategy Risks 72927.2 Market Risk 73027.3 Operational Risk 73227.4 Investment Process Risk 73427.5 Controlling Operational Risk 73627.6 Aggregating the Risks of a Fund 740


Contents xi

27.7 Portfolios with Options 74227.8 Conclusion 745

CHAPTER 28Due Diligence of Fund Managers 74728.1 Screening with Three Fundamental Questions 74828.2 Structural Review 75228.3 Strategic Review 75628.4 Administrative Review 76028.5 Performance Review 76128.6 Portfolio Risk Review 76728.7 Legal Review 77028.8 Reference Checks 77328.9 Measuring Operational Risk 774

CHAPTER 29Regression, Multivariate, and Nonlinear Methods 77729.1 Single-Factor Models and Regression 77729.2 Multiple-Factor Models and Regression 78129.3 Nonlinear Returns 78329.4 Changing Correlation 78529.5 Applications of Multifactor Models 78729.6 Hedge Fund Performance Persistence 791

CHAPTER 30Portfolio Optimization and Risk Parity 79530.1 Mean-Variance Portfolio Optimization 79530.2 Complications to Mean-Variance Optimization 80330.3 Risk Budgeting 80730.4 Risk Parity 810

CHAPTER 31Portfolio Management, Alpha, and Beta 81931.1 The Estimation of Alpha and Beta 81931.2 The Separation of Alpha and Beta 82131.3 Portable Alpha 82231.4 Alpha, Beta, and Portfolio Allocation 82731.5 Conclusion 831

APPENDIXData Sources 833

Index 849

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JWBT670-Preface JWBT670-CAIA March 5, 2012 17:9 Printer: Courier Westford

Preface

S ince its inception in 2002, the Chartered Alternative Investment Analyst (CAIA)Association has strived to incorporate state-of-the-art reading materials in its cur-

riculum. This latest curriculum reading, part of the Chartered Alternative InvestmentAnalyst Series, represents a milestone in our efforts to continuously improve and up-date our curriculum. To ensure that the material best reflects current practices inthe area of alternative investments, the CAIA Association invited a group of leadingindustry professionals to contribute to the production of the series, covering coreareas of alternative investments: hedge funds, commodities, real estate, structuredproducts, and private equity. Similar to other books published by the CAIA Associa-tion, this book is grounded in the CAIA Program Core Knowledge OutlineSM. MarkAnson, CAIA, has been contributing to the development of the CAIA curriculumsince the Association’s beginnings. He brings more than 20 years of experience inalternative assets to writing this first book in our series. We are proud to make thisbook available to our candidates and alternative investment industry professionals.This edition of the series is being launched in 2012 when aspiring, as well as accom-plished, alternative investment professionals will endeavor to master the materialcovered in this book, as well as other readings as outlined in the CAIA study guides,in order to earn the prestigious CAIA designation.

In publishing the books in this series, we are guided by the Association’s missionto provide its members with a comprehensive knowledge of alternative investments,advocate high standards of professional conduct, and establish the Chartered Al-ternative Investment Analyst designation as the educational gold standard for thealternative investment industry.

FOUNDATION

The quality, rigor, and relevance of this series derive from the ideals upon which theCAIA Association was based. The CAIA program offered its first Level I examinationin February 2003. We now have over 5,400 members, but in its first full year only 43candidates, who passed Level I and Level II exams and met the other requirementsof membership, were invited to join the CAIA Association. Many of these foundingmembers were instrumental in establishing the CAIA designation as the global markof excellence in alternative investment education. Through their support and with thehelp of the founding cosponsors, the Alternative Investment Management Associa-tion (AIMA) and the Center for the International Securities and Derivatives Markets(CISDM), the Association is now firmly established as the most comprehensive andcredible designation in the rapidly growing sphere of alternative investments.

The AIMA is the hedge fund industry’s global, not-for-profit trade association,with over 1,300 corporate members worldwide. Members include leading hedge

xiii



xiv PREFACE

fund managers, fund of hedge funds managers, prime brokers, legal and accountingservices, and fund administrators. They all benefit from the AIMA’s active influencein policy development; its leadership in industry initiatives, including education andsound practice manuals; and its excellent reputation with regulators.

The CISDM of the Isenberg School of Management of the University ofMassachusetts–Amherst seeks to enhance the understanding of the field of alter-native investments through research, education, and networking opportunities formember donors, industry professionals, and academics.

Led by Florence Lombard, Chief Executive Officer of the Association;Dr. Thomas Schneeweis, Director of the CISDM; and a core group of faculty andindustry experts who were associated with the University of Massachusetts andAIMA, the CAIA program took shape and was introduced to the investment com-munity through the publication of its first set of CAIA study guides in 2002. Fromthe beginning, the Association recognized that a meaningful portion of its curriculummust be devoted to codes of conduct and ethical behavior in the investment profes-sion. To this end, with permission and cooperation of the CFA Institute, we haveincorporated its Code of Ethics and the CFA Standards of Practice Handbook intoour curriculum. Further, we leverage the experience and contributions of our mem-bership and other distinguished alternative investment professionals on our boardand committees to create and update the CAIA Program Core Knowledge OutlineSM.

The CAIA Association has experienced rapid growth in its membership duringthe past 10 years. We strive to stay nimble in our process so that curriculum devel-opments remain relevant and keep pace with the constant changes in this dynamicindustry. Yet we never lose sight of the fact that we complement the still largertraditional and established investment arena.

This series focuses on the core topics that comprise each of the basic areas ofalternative investments, but our original philosophy to remain adept in updating ourreadings will serve us especially well now. Given the recent turmoil in the markets,the ability to keep pace with the regulatory and economic changes is more importanttoday than it has ever been in our history. This series, including the annually revised,most advanced material contained in our CAIA Level II: Core and Integrated Topics,reflects the current state of the industry.

BENEF ITS

While the CAIA Association’s origins are largely due to the efforts of professionalsin the hedge fund and managed futures space, these founders correctly identified avoid in the wider understanding of the alternative investments as a whole. Fromthe beginning, the CAIA curriculum has also covered private equity, commodities,and real assets and always with an eye toward shifts in the industry. Today, severalhundred CAIA members identify their main area of expertise as real estate or privateequity; several hundred more members are from family offices, pension funds, en-dowments, and sovereign wealth funds that allocate across multiple classes within thealternative investment industry. To accomplish this comprehensively, we have fullydeveloped curriculum subcommittees that represent each area of coverage within thecurriculum. All of these alternative investment areas share many distinct features,such as the relative freedom on the part of investment managers to act in the best



Preface xv

interests of their investors, alignment of interests between investors and management,relative illiquidity of positions for some investment products, and deviations fromsome of the underpinning assumptions of modern portfolio theory. These charac-teristics necessitate conceptual and actual modifications to the standard investmentperformance analysis and decision-making paradigms.

Readers will find the publications in our series to be beneficial whether from thestandpoint of allocating to new asset classes and strategies in order to gain broaderdiversification or from the standpoint of a specialist needing to better understand thecompeting options available to sophisticated investors globally. In either case, readerswill be better equipped to serve their clients’ needs. The series has been designedto make studying more efficient relative to our past curriculum. Importantly, it ismore relevant, having been written under the direction of the CAIA Associationwith the input and efforts of many practicing and eminent alternative investmentprofessionals, as reflected in each publication’s acknowledgments section.

THE CAIA PROGRAMS AND CAIA ALTERNATIVEINVESTMENT ANALYST SERIES

The Foundations of the CAIA Curriculum is an assessment tool to determine a candi-date’s readiness to enter the CAIA program. These foundational materials cover thequantitative analytics commonly associated with traditional assets, as well as a blendof practical and theoretical knowledge relating to both traditional and alternativeinvestments.

The first book in our series, CAIA Level I: An Introduction to Core Topics inAlternative Investments, is a twice-revised edition of Mark Anson’s Handbook ofAlternative Assets. The CAIA Level I required readings are contained in this onetext, supplemented only by the CFA Institute’s Standards of Practice Handbook.Readers should be aware, however, that the Foundations program is important andthat Level I candidates are assumed to have mastered all of its content in advance oftaking the Level I exam.

The second book in our series, CAIA Level II: Advanced Core Topics in Alter-native Investments, also represents a significant improvement to the coverage of ourcurriculum. The tools candidates develop in Level I of the CAIA program are appliedin the Level II curriculum, which will integrate alternative investments into investorportfolios as well as present risk management across asset classes. We believe thisnew model of curriculum development accurately reflects the skill set required ofindustry practitioners.

The third volume in this series is titled CAIA Level II: Core and IntegratedTopics. It is updated annually and designed to address topics that cut across all areasof alternative investments, such as asset allocation and risk management techniques,as well as new developments in the alternative investment research space and inthe industry itself. This book is more frequently revised, which allows the Level IIcurriculum to rapidly adapt to new research trends in alternative investments ascovered in academic and practitioner journals.

Finally, we will continue to update the CAIA Level I Study Guide and theCAIA Level II Study Guide every six months (each exam cycle). These are freelyavailable on our web site. These guides outline all of the readings and corresponding



xvi PREFACE

learning objectives (LOs) that candidates are responsible for meeting. They alsocontain important information for candidates regarding the use of LOs, testingpolicies, topic weightings, where to find and report errata, and much more. Theentire exam process is outlined in the CAIA Candidate Handbook and is availableat http://caia.org/caia-program/exams/candidate-handbook.

I believe you will find this series to be the most comprehensive, rigorous, andglobally relevant source of educational material available within the field of alterna-tive investments.

DONALD R. CHAMBERS, PhD, CAIAAssociate Director of CurriculumCAIA AssociationMarch 2012

http://caia.org/caia-program/exams/candidate-handbook


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Acknowledgments

We would like to thank the many individuals who played important roles inproducing this book. The following people were instrumental in bringing this

project to its completion: Sue Bannon, Mark Bhasin, James Burron, Jason Campbell,Yingwen Chin, Paul Chow, Michael Cimmino, William Coverley, Melville du Plessis,Eelco Fiole, Jason Flowers, Michael Godsey, Robert Murphy, Ethan Namvar,Michael Newman, Kweku Obed, Robert O’Donnell, Timothy Peterson, Daryl Purdy,David Shen, Jayesh Soneji, Klaus Springer, Timothy Walkley, Hilary Wiek, JanetYuen, Walter Zebrowski.

Importantly, we owe great thanks to Florence Lombard, Chief Executive Officerof the CAIA Association, and our committee members:

Curriculum Advisory Council

Mark Baumgartner

Jaeson Dubrovay

David McCarthy

Armand van Houten

Garry Crowder

James Tomeo, COO

Daniel Celeghin

Angelo A. Calvello

Hedge Funds and Fund of Hedge Funds Committee

Solomon Tadesse

Jaeson Dubrovay

Daniel Celeghin

Mark Hutchinson

Mark Wiltshire

Real Assets Committee

Stephane Amara

George A. Martin

Andreas Calianos

Tom Johnson

Asif Hussain

xvii



xviii ACKNOWLEDGMENTS

Commodities & CTAs Committee

Hamlin Lovell

David McCarthy

Hilary Till

Joelle Miffre

Richard Spurgin

Private Equity Committee

Pierre-Yves Mathonet

Thomas Meyer

James Bachman

Erik Benrud

Gitanjali M. Swam

Due Diligence and Regulation Committee

Jaeson Dubrovay

Armand van Houten

Tom Kehoe

Hamlin Lovell

Christopher Schelling

Mark Wiltshire

Asset Allocation, Risk Management and Wealth Management Committee

Solomon Tadesse

Joelle Miffre

James T. Gillies

Pierre Laroche

Structured Products Committee

Jon Rotolo

Samson Koo

* * *

CAIA Editorial Staff

Kathy Champagne

Urbi Garay, PhD

Nelson Lacey, PhD, CFA

Kristaps Licis



Acknowledgments xix

CAIA Curriculum Group

Hossein Kazemi, PhD, CFA, Program Director

Donald R. Chambers, PhD, CAIA, Associate Director & Level I Manager

Keith H. Black, PhD, CFA, CAIA, Associate Director & Level II Manager

Jeanne Miller, Project Manager

Andrew Tetreault, Assistant

Melissa Donahue, PhD, Editorial Consultant


JWBT670-babout JWBT670-CAIA February 29, 2012 19:11 Printer: Courier Westford

About the Authors

The CAIA Association is an independent, not-for-profit global organization commit-ted to education and professionalism in the field of alternative investments, estab-lished in 2002 by industry leaders under the guidance of the Alternative InvestmentManagement Association (AIMA) and the Center for International Securities andDerivatives Markets (CISDM) with the belief that a strong foundation of knowledgeis essential for all professionals. The CAIA Association offers two exams (Level I andLevel II) to professional analysts in this growing field so that, upon successful com-pletion, the individuals are designated “Chartered Alternative Investment Analysts”(CAIA). Since only a small number of exam takers pass, this designation has a greatdeal of prestige in the global community. Members come from over 75 countries onsix continents.

Dr. Mark J. P. Anson is a Managing Partner at Oak Hill Investment Management,L.P. Dr. Anson previously served as President and Executive Director of InvestmentServices at Nuveen Investments Inc., Chief Executive Officer at Hermes PensionManagement Limited, and Chief Investment Officer at California Public Employees’Retirement System. He has published over 100 research articles in professional jour-nals, has won two Best Paper Awards, is the author of six financial textbooks, andsits on the editorial boards of several financial journals.

Dr. Donald R. Chambers is the Associate Director of the Level I Curriculum atthe CAIA Association and is the Walter E. Hanson/KPMG Professor of Finance atLafayette College in Easton, Pennsylvania. Dr. Chambers previously served as theDirector of Alternative Investments at Karpus Investment Management.

Dr. Keith H. Black is the Associate Director of the Level II Curriculum at the CAIAAssociation. He was previously an Associate at Ennis Knupp and, before that, anAssistant Professor at Illinois Institute of Technology.

Dr. Hossein Kazemi is the Program Director for the CAIA Association. Dr. Kazemi isa Professor of Finance at the University of Massachusetts–Amherst, an Associate Di-rector of the Center for International Securities & Derivatives Markets, a co-founderof the CAIA Association, and an Associate Editor of The Journal of AlternativeInvestments.

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PART

OneIntroduction to

Alternative Investments

Part One provides an introduction to alternative investments, descriptions of theenvironment, and a primer on asset pricing, along with statistical methodologies

and quantitative methodologies for alternative investing. The material is designedto provide a foundation for the middle five parts of the book that detail each ofthe five main categories of alternative investments. The final part of the book pro-vides an introduction to portfolio management from the perspective of alternativeinvestments.

1



CHAPTER 1What Is an Alternative Investment?

Definitions of what constitutes an alternative investment vary substantially. Onereason for these differences lies in the purposes for which the definitions are being

used. But definitions also vary because alternative investing is largely a new field forwhich consensus has not emerged, and it also is a rapidly changing field for whichconsensus will probably always remain elusive.

Analyzing these various definitions provides a useful starting point to under-standing alternative investments. So we begin this introductory chapter by examiningcommonly used methods of defining alternative investments.

1.1 ALTERNATIVE INVESTMENTS BY EXCLUSION

Alternative investments are sometimes viewed as including any investment that isnot simply a long position in traditional investments. Typically, traditional invest-ments include long positions in equities, fixed income, and cash. For example, if aparticular investment such as private equity is not commonly covered as equity inbooks on investments, then many people would view the investment as an alternativeinvestment.

The alternative investments by exclusion definition is overly broad for the pur-poses of the CAIA curriculum. First, the term investment includes a very broadspectrum. A good definition of an investment is that it is deferred consumption.Any outlay of cash made with the prospect of receiving future benefits might beconsidered an investment. So investments can range from planting a tree to investingin stocks to college educations. As such, a more accurate definition of alternativeinvestments requires more specificity than simply that of being nontraditional.

This book and the overall CAIA curriculum are focused on institutional-qualityalternative investments. An institutional-quality investment is the type of investmentthat financial institutions such as pension funds or endowments might include in theirholdings because they are expected to deliver reasonable returns at an acceptablelevel of risk. For example, a pension fund would consider holding the publiclytraded equities of a major corporation but may be reluctant to hold collectibles suchas baseball cards or stamps. Also, investments in very small and very speculativeprojects are typically viewed as being inappropriate for a financial institution suchas a pension fund due to the fund’s duty to select investments that offer suitable risklevels and financial return prospects for its clients.

3



4 INTRODUCTION TO ALTERNATIVE INVESTMENTS

Not every financial institution or even every type of financial institution investsin alternative investments. Some financial institutions, such as some brokerage firms,are not focused on making long-term investments; rather, they hold securities toprovide services to their clients. Other financial institutions, such as deposit-takinginstitutions like banks, especially smaller banks, might invest in only traditionalinvestments because of government regulations or because of lack of expertise.

Of course, institutional-quality alternative investments are also held by entitiesother than financial institutions. Chapter 2 of this book discusses the environment ofalternative investments, including the various entities that commonly hold alternativeinvestments. For example, alternative investments are commonly held by endowmentfunds and wealthy individuals, to name a few.

1.2 ALTERNATIVE INVESTMENTS BY INCLUSION

Another method of identifying alternative investments is to define explicitly whichinvestments are considered to be alternative investments. In this book, we classifyfive types of alternative investments:

1. Real Assets (including real estate, real estate investment trusts, land, and infras-tructure)

2. Hedge Funds3. Commodities4. Private Equity (including mezzanine and distressed debt)5. Structured Products (including credit derivatives)

Our list is not an exhaustive list of all alternative investments—especially be-cause the CAIA curriculum is focused on institutional-quality investments. Further-more, some of the investments on the list can be classified as traditional investmentsrather than alternative investments. For example, real estate and especially real es-tate investment trusts are frequently viewed as being traditional institutional-qualityinvestments. Nevertheless, this list includes most institutional-quality investmentsthat are currently commonly viewed as alternative. Exhibit 1.1 illustrates the relativeproportion of the first four of these categories of alternative investments.

The following sections provide brief introductions to the five categories.

1.2.1 Real Assets

The category of real assets focuses on investments in which the underlying assetsinvolve direct ownership of nonfinancial assets rather than ownership through fi-nancial assets such as the securities of manufacturing or service enterprises. Realassets tend to represent more direct claims on consumption than common stocks,and they tend to do so with less reliance on factors that create value in a com-pany, such as intangible assets and managerial skill. So while a corporation suchas Google holds real estate and other real assets, the value to its common stock ishighly reliant on perceptions of the ability of the firm to create and sell its goods andservices.



What Is an Alternative Investment? 5

Real Assets, 37%

Hedge Funds, 34%

Commodi�es, 5%

Private Equity, 24%

EXHIB IT 1.1 Major Alternative Asset Categories(percentages, approximate) 2010Source: Russell Investments’ 2010 Global Survey onAlternative Investing.

Real estate focuses on land and improvements that are permanently affixed,like buildings. Real estate was a significant asset class long before stocks and bondsbecame important. In times prior to the industrial age, land was the single mostvaluable asset class. Only a few decades ago, real estate was the most valuable assetof most individual investors because the ownership of a primary residence was morecommon than ownership of financial investments.

Timberland includes both the land and the timber of forests of tree speciestypically used in the forest products industry. While the underlying land is clearlyreal estate, the timber on the land is not typically regarded as real estate since it isnot permanently affixed to the land. Thus, timberland is discussed as a real asset,but it is not included as a subset of real estate in the CAIA curriculum. Other similarreal assets include raw land and farmland.

Infrastructure investments are claims on the income of toll roads, regulated util-ities, ports, airports, and other real assets that are traditionally held and controlledby the public sector (i.e., various levels of government). Investable infrastructure op-portunities include securities generated by the privatization of existing infrastructureor by the private creation of new infrastructure via private financing.

Finally, while some descriptions of real assets limit the category to tangibleassets, we define real assets to include intangible assets, such as intellectual property(e.g., patents, copyrights, trademarks, and music, film, and publishing royalties).The opposite of a real asset is a financial asset, not an intangible asset. A financialasset is a direct claim on cash flows such as provided by a share of stock or a bond.Intangible assets such as the copyright on a book can provide direct claims on future



6 INTRODUCTION TO ALTERNATIVE INVESTMENTS

consumption (such as the enjoyment from reading) in a manner quite similar to theability of sports stadiums to generate entertainment. In fact, intangible assets can beargued to represent a very large and rapidly increasing role in the wealth of society.

1.2.2 Hedge Funds

Hedge funds represent perhaps the most visible category of alternative investments.While hedge funds are often associated with particular fee structures or levels of risktaking, we define a hedge fund as a privately organized investment vehicle that usesits less regulated nature to generate investment opportunities that are substantiallydistinct from opportunities offered by traditional investment vehicles, which aresubject to regulations such as those restricting their use of derivatives and leverage.Hedge funds represent a wide-ranging set of vehicles that are differentiated primarilyby the investment strategy or strategies implemented.

1.2.3 Commodit ies

Commodities are investments distinguished by their emphasis on futures contracts,their emphasis on physical commodities, or both. Commodities are homogeneousgoods available in large quantities, such as energy products, agricultural products,metals, and building materials. Futures contracts refer to traditional futures con-tracts, as well as closely related derivative products, such as forward contracts andswaps. Most of the investments covered in the commodities section of the CAIAcurriculum involve futures contracts. Futures contracts are regulated distinctly andhave well-defined economic properties. For example, the analysis of futures contractstypically emphasizes notional amounts rather than the amount of money posted ascollateral or margin to acquire positions.

Commodities as an investment class refer to investment products with somewhatpassive (i.e., buy-and-hold) exposure to commodity prices. This exposure can be ob-tained through futures contracts, physical commodities, natural resource companies,and exchange-traded funds.

1.2.4 Private Equity

The term private equity is used in the CAIA curriculum to include both equity anddebt positions that, among other things, are not publicly traded. In most cases, thedebt positions contain so much risk from cash flow uncertainty that their short-termreturn behavior is similar to that of equity positions. In other words, the value of thedebt positions in a highly levered company, discussed within the category of privateequity, behaves much like the equity positions in the same firm, especially in theshort run. Private equity investments emerge primarily from funding new ventures,known as venture capital; from the equity of leveraged buyouts (LBOs) of existingbusinesses; from mezzanine financing of LBOs or other ventures; and from distresseddebt resulting from the decline in the health of previously healthy firms.

Venture capital refers to support via equity financing to start-up companiesthat do not have a sufficient size, track record, or desire to attract capital fromtraditional sources, such as public capital markets or lending institutions. Venturecapitalists fund these high-risk, illiquid, and unproven ideas by purchasing senior

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