Alternative Investments

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Transcript of Alternative Investments

  • 1. Alternative Investments : A Primer By A.V. Vedpuriswar (Based on the CFA Institute curriculum and study material)

2. Introduction

  • Alternative assets refer to alternative asset classes (assets other then plain vanilla equities and bonds) and alternative investment (more sophisticated, leveraged) strategies.
  • Mutual funds, hedge funds, venture capital, distressed securities, closely held companies, real estate, commodities, art, etc aregood examples .
  • Theseinvestments often involve less liquidity, longer time horizons and difficulties in establishing fair valuation.


  • Mutual fundscan be classified into one of two categories, depending upon the liquidity they provide to their investors.
  • An open-end fund, stands ready to redeem sharesat the closing valueon any trading day.
  • In a closed-end fund, shares are traded in the secondary markets through organized exchanges .
  • Thus the liquidity of an open-end fund is provided by the investment company that manages it.
  • While the liquidity of a closed-end fund is determined in the open market.

MutualFunds 4.

  • The managers of an open-end fund may charge a fee, or load, to the investors upon purchase (a front-end load) or at redemption (a back-end load).
  • A fund that charges no fee at purchase or redemption is called a no-load fund.
  • All funds, regardless of whether they are load or no-load funds, will charge ongoing fees on a annual basis, which may include management fees, administrative fees, and distribution (marketing) fees.

Load and no load funds 5.

  • The term load and no-load are not applicable to closed-end funds.
  • The shares of a closed-end fund will be issued at a small premium to the value of the underlying assets, the premium serving as compensation for issuance costs.
  • The investment company will also charge an ongoing management fee.
  • Since a closed-end fund is traded in the secondary market subsequent to issuance, theredemption cost for the investor is simply the commission charged on the sale of shares and a portion of the bid/ask spread of the shares.

Closed end funds 6.

  • The net asset value (NAV) of a mutual fund is the value of the investment company's assets minus its liabilities, stated on a per-share basis.
  • The share price of an open-end fund will always equal the NAV since the investment company is obligated to redeem shares at any time at this value.
  • The share price of a closed-end fund may or may not equal the NAV since the share price is determined in the secondary market.
  • The shares may trade at a premium or at a discount to the actual NAV of the funds assets.

Net Asset value 7.

  • Closed-end funds initially issue shares at a premium to the value of the funds underlying assets, which essentially is a fee paid by the investors as compensation for issuance costs.
  • Premiums, loads, and redemption fees are, in essence, compensation for the sales and marketing efforts.
  • In addition, thereare performance incentives for the portfolio managers.
  • The expenses and fees charged by the investment companies decrease an investors return .
  • With differences in up-front, back-end, and ongoing distribution fees among the classes, an investor's anticipated holding period (time horizon) will be an important determinant of which class of shares and associated fee structure will be most advantageous.

Fees and incentives 8.

  • The style of an equity fund describes the basic characteristics of the underlying assets, such as growth versus value or large cap versus small cap.
  • Asectorstrategy would have the investment fund concentrate its assets in a specific industry .
  • An i ndexfund strives to match returns to those of a particular stock index, such as the S&P 500.
  • Aglobalfund strategy will invest in securities from all over the world, including those from the investment companys home country.
  • Astable valuefund invests in short-term government securities or other investments that can provide timely principal payments and a set interest rate .

Characteristics of funds 9.

  • An exchange traded fund (ETF) is a special type of fundthat invests in a portfolio of stocks or bonds and is designed to mimic the performance of a specified index.
  • Shares are traded in the secondary market like the shares of a closed-end fund, with the investor having the ability to trade at any time during market hours.
  • Although they trade like shares of a closed-end fund, the legal structure of most ETFs in the U.S is that of a traditional (open-end) mutual fund.
  • The creation and redemption of shares is somewhat different, however.

Exchange traded fund 10.

  • A feature unique to ETFs is their use of in-kind creation and redemption of shares.
  • Exchange specialists, call authorized participants, are established by the fund to ensure an efficient, orderly market in the shares.
  • An authorized participant can create new shares in the ETF by depositing with a trustee a portfolio of stocks that track the index.
  • The authorized participant then receives from the trustee new ETF shares to be sold in the open market.
  • Conversely, the authorized participant can redeem shares to the trustee in exchange for the underlying stocks.


  • There are several characteristics unique to real estate that differ from other asset classes.
  • A real estate investment is immobile, not divisible, and unique from all other real estate properties.
  • Since each property is unique, it is impossible to directly compare to other properties, making it difficult to determine true market value.
  • For these reasons, real estate as an asset class is somewhat illiquid.
  • .

Real Estate 12.

  • Some indexes are based on appraised values for the real estate.
  • The use of appraised values tends to smooth the returns of appraisal-based indexes relative to market prices.
  • In portfolio optimization models, appraisal-based indexes will tend to have very large weight because of their low volatility and low correlation with important asset-class proxies such as the S&P 500 stock index.
  • Many analysts consider this a very serious drawback of appraisal-based indexes .
  • Other real estate indexes are based on the performance of the shares of Real Estate Investment Trusts (REITs).


  • With thecostmethod, value is determined by the replacement cost of improvements plus an estimate for the value of the land.
  • Thesales comparison method uses the price of a similar property or properties from recent transactions.
  • Valuation can then be done relative to a specific similar property or relative to a benchmark such as the mean or median home price in the area.
  • Then additions (e.g., for more square feet) and subtractions (e.g., for poor locations) are made to estimate the value of the subject property.

Valuation 14. Hedonic approach

  • A more detailed method of the sales comparison approach ishedonicprice estimation, where specific characteristics of property are quantified .
  • This involves creating a statistical model of the sales prices of properties, showing how the prices are related to certain key characteristics that influence the value of a property.
  • The model produces an estimate of how much each of these factors contributes to the value of a property on average.

15. The Income method

  • Theincomemethod uses a discounted cash flow model to estimate the present value of the stream of annual net operating income using the required rate of return for the property.

16. Venture Capital

  • Venture capital investments are private, non-exchange-traded equity investments in a business venture.
  • Investments are usually made through limited partnerships.
  • Investors expect relatively high returns in exchange for the illiquidity and high risk profile of a venture capital investment.


  • Illiquidity.Investors ability to cash out is dependent upon a successful IPO, which probably will not occur in the short term, if ever.
  • Long-term investment horizon.Market conditions must be conducive for a public offering, and the company most have broken even .
  • Difficulty in valuation . Because of the uniqueness of each investment, there are few comparable assets with meaningful trading volume available for market value comparisons.

Venture capital investment characteristics: 18.

  • Limited data.There is not much comparable historical risk and return data, nor is there much information on which to base future cash flows and earnings estimates.There is insufficient information on what competing ideas or products other entrepreneurs may be developing.
  • Entrepreneur / management mismatches.Entrepreneurs with good ideas dont always necessarily evolve into good managers as their company grows.