Alternative Investments

CFA Institute is the global association of investment professionals that sets the standard for professional excellence and credentials. The organization is a champion for ethical behavior in investment markets and a respected source of knowledge in the global financial community. The end goal: to create an environment where investors' interests come first, markets function at their best, and economies grow. CFA Institute has more than 170,000 members in 160+ countries and territories, including 163,000 CFA charterholders, and 150+ member societies. For more information, visit www.cfainstitute.org.

• Foreword xvPreface xviiAcknowledgments xixAbout the CFA Institute Investment Series xxiChapter 1 Introduction to Corporate Governance and Other ESG1. Introduction and Overview of Corporate Governance 21.1. Corporate Governance Overview 22. Stakeholder Groups 42.1. Stakeholder Groups 43. Principal– Agent and Other Relationships in Corporate Governance 73.1. Shareholder and Manager/Director Relationships 83.2. Controlling and Minority Shareholder Relationships 83.3. Manager and Board Relationships 93.4. Shareholder versus Creditor Interests 93.5. Other Stakeholder Conflicts 104. Overview and Mechanisms of Stakeholder Management 104.1. Overview of Stakeholder Management 104.2. Mechanisms of Stakeholder Management 115. Mechanisms to Mitigate Associated Stakeholder Risks 155.1. Employee Laws and Contracts 165.2. Contractual Agreements with Customers and Suppliers 175.3. Laws and Regulations 176. Company Boards and Committees 186.1. Composition of the Board of Directors 186.2. Functions and Responsibilities of the Board 196.3. Board of Directors Committees 207. Relevant Factors in Analyzing Corporate Governance and Stakeholder Management 227.1. Market Factors 227.2. Non- Market Factors 248. Risks and Benefits of Corporate Governance and Stakeholder Management 258.1. Risks of Poor Governance and Stakeholder Management 268.2. Benefits of Effective Governance and Stakeholder Management 279. Factors Relevant to Corporate Governance and Stakeholder Management Analysis 289.1. Economic Ownership and Voting Control 299.2. Board of Directors Representation 299.3. Remuneration and Company Performance 309.4. Investors in the Company 319.5. Strength of Shareholders' Rights 319.6. Managing Long- Term Risks 329.7. Summary of Analyst Considerations 3210. ESG Considerations for Investors and Analysts 3310.1. Introduction to Environmental, Social, and Governance issues 3310.2. ESG Investment Strategies 3410.3. ESG Investment Approaches 3510.4. Catalysts for Growth in ESG Investing 3810.5. ESG Market Overview 3910.6. ESG Factors in Investment Analysis 39Chapter 2 Introduction to Alternative Investments 451. Introduction 451.1. Why Investors Consider Alternative Investments 461.2. Categories of Alternative Investments 472. Investment Methods 492.1. Methods of Investing in Alternative Investments 492.2. Advantages and Disadvantages of Direct Investing, Co- investing, and Fund Investing 512.3. Due Diligence for Fund Investing, Direct Investing, and Co- investing 543. Investment and Compensation Structures 563.1. Partnership Structures 563.2. Compensation Structures 583.3. Common Investment Clauses, Provisions, and Contingencies 594. Hedge Funds 624.1. Characteristics of Hedge Funds 624.2. Hedge Fund Strategies 664.3. Hedge Funds and Diversification Benefits 715. Private Capital 715.1. Overview of Private Capital 715.2. Description: Private Equity 725.3. Description: Private Debt 765.4. Risk/Return of Private Equity 795.5. Risk/Return of Private Debt 795.6. Diversification Benefits of Investing in Private Capital 816. Natural Resources 826.1. Overview of Natural Resources 826.2. Characteristics of Natural Resources 836.3. Risk/Return of Natural Resources 876.4. Diversification Benefits of Natural Resources 906.5. Instruments 957. Real Estate 967.1. Overview of the Real Estate Market 967.2. Characteristics: Forms of Real Estate Ownership 987.3. Characteristics: Real Estate Investment Categories 1037.4. Risk and Return Characteristics 1057.5. Diversification Benefits 1088. Infrastructure 1108.1. Introduction and Overview 1108.2. Description 1128.3. Risk and Return Characteristics 1148.4. Diversification Benefits 1179. Issues in Performance Appraisal 1189.1. Overview of Performance Appraisal for Alternative Investments 1189.2. Common Approaches to Performance Appraisal and Application Challenges 1199.3. Private Equity and Real Estate Performance Evaluation 1229.4. Hedge Funds: Leverage, Illiquidity, and Redemption Terms 12410. Calculating Fees and Returns 12810.1. Alternative Asset Fee Structures and Terms 12910.2. Custom Fee Arrangements 12910.3. Alignment of Interests and Survivorship Bias 134Chapter 3 Real Estate Investments 145Section A. Overview of Types of Real Estate Investment 1461. Introduction and Basic Forms of Real Estate Investment 1461.1. Real Estate Market Size 1471.2. Real Estate Investment: Basic Forms 1471.3. Characteristics 1501.4. Risk Factors 1532. Economic Value Drivers, Role in Portfolio, and Risk/Return of Real Estate Investments Relative to Stocks and Bonds 1572.1. Economic Drivers 1572.2. Role of Real Estate in an Investment Portfolio 1602.3. Real Estate Risk and Return Relative to Stocks and Bonds 1632.4. Classifications 1662.5. Investment Characteristics by Property Type 1683. Considerations in Analysis and Due Diligence 1734. Indexes 1754.1. Appraisal- Based Indexes 1754.2. Transaction- Based Indexes 1764.3. Advantages and Disadvantages of Appraisal- Based and Transaction- Based Indexes 1774.4. Real Estate Security Indexes 179Section B. Investments in Real Estate through Private Vehicles 1795. Introduction to Valuation Approaches 1795.1. Highest and Best Use 1816. The Income Approach to Valuation: Discount Rates and the Direct Capitalization of NOI and DCF Methods 1826.1. Similarities in Approaches 1836.2. The Direct Capitalization Method 1837. The DCF Method, the Relationship between Discount Rate and Cap Rate, and the Terminal Capitalization Rate 1877.1. The Relationship between the Discount Rate and the Cap Rate 1877.2. The Terminal Capitalization Rate 1898. Private Market Real Estate Debt 194Section C. Investments in Real Estate Through Publicly Traded Securities 1979. Types of Publicly Traded Real Estate Securities 1979.1. REIT Structures 1989.2. Market Size 1999.3. Benefits and Disadvantages of Investing in REITs 20010. Valuation: Net Asset Value Approach 20310.1. Accounting for Investment Properties 20310.2. Net Asset Value per Share: Calculation 20410.3. Net Asset Value per Share: Application 20611. Valuation: Relative Value (Price Multiple) Approach 20811.1. Relative Value Approach to Valuing REIT Stocks 20811.2. Funds from Operations and Adjusted Funds from Operations 20911.3. P/FFO and P/AFFO Multiples: Advantages and Drawbacks 21412. REIT Mini Case Study: Example of Disclosures and Valuation Analysis 21512.1. Selection of Valuation Methods 22113. Private versus Public: A Comparison 223Chapter 4 Private Equity Investments 2391. Introduction 2392. Introduction to Valuation Techniques in Private Equity Transactions 2412.1. How Is Value Created in Private Equity? 2442.2. Using Market Data in Valuation 2473. Contrasting Venture Capital and Buyout Investments 2484. LBO model for valuation of Buyout Transactions 2494.1. The LBO Model 2505. VC Method for valuation of Venture Capital Transactions 1 2535.1. Expected Exit Valuation 2545.2. Required Rate of Return 2545.3. Option Pools 2555.4. Stage Financing 2566. Exit Routes: Return Cash to Investors 2586.1. Exit Routes: Summary 2597. Risks and Costs of investing in Private Equity 2607.1. What Are the Risks and Costs of Investing in Private Equity? 2608. Private Equity Fund Structures and Terms 2618.1. Economic Terms 2638.2. Corporate Governance Terms 2648.3. Due Diligence Investigations by Potential Investors 2668.4. Private Equity Fund Valuation 2669. Evaluating Fund Performance and Concept in Action: Evaluating a Private Equity Fund 2679.1. Analysis of IRR since Inception 2679.2. Analysis of Return Multiples 268Chapter 5 Introduction to Commodities and Commodity Derivatives 2791. Introduction 2792. Commodity Sectors 2802.1. Commodity Sectors 2823. Life Cycle of Commodities 2843.1. Energy 2853.2. Industrial/Precious Metals 2863.3. Livestock 2873.4. Grains 2883.5. Softs 2894. Valuation of Commodities 2905. Commodities Futures Markets: Participants 2925.1. Futures Market Participants 2926. Commodity Spot and Futures Pricing 2957. Theories of Futures Returns 3007.1. Theories of Futures Returns 3008. Components of Futures Returns 3069. Contango, Backwardation, and the Roll Return 31110. Commodity Swaps 31310.1. Total Return Swap 31510.2. Basis Swap 31510.3. Variance Swaps and Volatility Swaps 31611. Commodity Indexes 31711.1. S&p Gsci 31911.2. Bloomberg Commodity Index 32011.3. Deutsche Bank Liquid Commodity Index 32011.4. Thomson Reuters/CoreCommodity CRB Index 32011.5. Rogers International Commodity Index 32111.6. Rebalancing Frequency 32111.7. Commodity Index Summary 321Chapter 6 Hedge Fund Strategies 3311. Introduction and Classification of Hedge Fund Strategies 3311.1. Classification of Hedge Funds and Strategies 3332. Equity Strategies: Long/Short Equity 3362.1. Long/Short Equity 3373. Equity Strategies: Dedicated Short Selling and Short- Biased 3403.1. Investment Characteristics 3403.2. Strategy Implementation 3424. Equity Strategies: Equity Market Neutral 3444.1. Investment Characteristics 3454.2. Strategy Implementation 3465. Event- Driven Strategies: Merger Arbitrage 3485.1. Merger Arbitrage 3486. Event- Driven Strategies: Distressed Securities 3516.1. Investment Characteristics 3526.2. Strategy Implementation 3537. Relative Value Strategies: Fixed Income Arbitrage 3557.1. Fixed- Income Arbitrage 3558. Relative Value Strategies: Convertible Bond Arbitrage 3598.1. Investment Characteristics 3608.2. Strategy Implementation 3619. Opportunistic Strategies: Global Macro Strategies 3639.1. Global Macro Strategies 36410. Opportunistic Strategies: Managed Futures 36710.1. Investment Characteristics 36710.2. Strategy Implementation 36811. Specialist Strategies 37111.1. Volatility Trading 37111.2. Reinsurance/Life Settlements 37512. Multi- Manager Strategies 37812.1. Fund- of- Funds 37812.2. Multi- Strategy Hedge Funds 38013. Analysis of Hedge Fund Strategies using a Conditional Factor Risk Model 38413.1. Conditional Factor Risk Model 38514. Evaluating Equity Hedge Fund Strategies: Application 38915. Evaluating Multi- manager Hedge Fund Strategies: Application 39416. Portfolio Contribution of Hedge Fund Strategies 39716.1. Performance Contribution to a 60/40 Portfolio 39716.2. Risk Metrics 400Chapter 7 Capital Market Expectations: Forecasting Asset Class Returns 4151. Introduction 4152. Overview of Tools and Approaches 4162.1. The Nature of the Problem 4162.2. Approaches to Forecasting 4163. Forecasting Fixed Income Returns 4183.1. Applying DCF to Fixed Income 4183.2. The Building Block Approach to Fixed- Income Returns 4204. Risks in Emerging Market Bonds 4264.1. Economic Risks/Ability to Pay 4264.2. Political and Legal Risks/Willingness to Pay 4275. Forecasting Equity Returns 4285.1. Historical Statistics Approach to Equity Returns 4295.2. DCF Approach to Equity Returns 4305.3. Risk Premium Approaches to Equity Returns 4325.4. Risks in Emerging Market Equities 4376. Forecasting Real Estate Returns 4386.1. Historical Real Estate Returns 4386.2. Real Estate Cycles 4396.3. Capitalization Rates 4406.4. The Risk Premium Perspective on Real Estate Expected Return 4416.5. Real Estate in Equilibrium 4426.6. Public versus Private Real Estate 4426.7. Long- Term Housing Returns 4437. Forecasting Exchange Rates 4457.1. Focus on Goods and Services, Trade, and the Current Account 4467.2. Focus on Capital Flows 4488. Forecasting Volatility 4538.1. Estimating a Constant VCV Matrix with Sample Statistics 4538.2. VCV Matrices from Multi- Factor Models 4548.3. Shrinkage Estimation of VCV Matrices 4558.4. Estimating Volatility from Smoothed Returns 456\8.5. Time- Varying Volatility: ARCH Models 4579. Adjusting a Global Portfolio 4599.1. Macro- Based Recommendations 4599.2. Quantifying the Views 461Chapter 8 Asset Allocation to Alternative Investments 4751. Introduction and The Role of Alternative Investments in a Multi- asset Portfolio 4751.1. The Role of Alternative Investments in a Multi- asset Portfolio 4762. Diversifying Equity Risk 4832.1. Volatility Reduction over the Short Time Horizon 4832.2. Risk of Not Meeting the Investment Goals over the Long Time Horizon 4863. Traditional Approaches to Asset Classification 4883.1. Traditional Approaches to Asset Classification 4884. Risk- Based Approaches to Asset Classification and Comparing Risk- Based and Traditional Approaches 4914.1. Illustration: Asset Allocation and Risk- Based Approaches 4954.2. Comparing Risk- Based and Traditional Approaches 4975. Risk Considerations, Return Expectations and Investment Vehicle 4995.1. Risk Considerations 4995.2. Return Expectations 5005.3. Investment Vehicle 5016. Liquidity 5026.1. Liquidity Risks Associated with the Investment Vehicle 5036.2. Liquidity Risks Associated with the Underlying Investments 5057. Fees and Expenses, Tax Considerations, and Other Considerations 5067.1. Tax Considerations 5077.2. Other Considerations 5078. Suitability Considerations 5108.1. Investment Horizon 5108.2. Expertise 5108.3. Governance 5118.4. Transparency 5119. Asset Allocation Approaches and Statistical Properties and Challenges of Asset Returns 5139.1. Statistical Properties and Challenges of Asset Returns 51410. Monte Carlo Simulation 51910.1. Simulating Skewed and Fat- Tailed Financial Variables 52010.2. Simulation for Long- Term Horizon Risk Assessment 52211. Portfolio Optimization 52611.1. Mean– Variance Optimization without and with Constraints 52611.2. Mean– CVaR Optimization 52812. Risk Factor- Based Optimization 53213. Liquidity Planning and Achieving and Maintaining the Strategic Asset Allocation 53513.1. Achieving and Maintaining the Strategic Asset Allocation 53614. Managing the Capital Calls and Preparing for the Unexpected 54214.1. Preparing for the Unexpected 54215. Monitoring the Investment Program 54715.1. Overall Investment Program Monitoring 54715.2. Performance Evaluation 54715.3. Monitoring the Firm and the Investment Process 549Chapter 9 Integrated Cases in Risk Management: Institutional 5631. Introduction 5632. Financial Risks Faced by Institutional Investors 5642.1. Long- Term Perspective 5642.2. Dimensions of Financial Risk Management 5642.3. Risk Considerations for Long- Term Investors 5672.4. Risks Associated with Illiquid Asset Classes 5692.5. Managing Liquidity Risk 5732.6. Enterprise Risk Management for Institutional Investors 5753. Environmental and Social Risks Faced by Institutional Investors 5773.1. Universal Ownership, Externalities, and Responsible Investing 5773.2. Material Environmental Issues for an Institutional Investor 5783.3. Material Social Issues for an Institutional Investor 584 Case Study 5861. Case Study: Introduction 5862. Case Study: Background 5863. R- SWF'S Investments: 1.0 5864. R- SWF'S Investments: 2.0 6035. R- SWF'S Investments: 3.0 616References 617Glossary 619About the Editors and Authors 627Index 631