Study session 18 concludes the Level I CFA Program curriculum with two readings (66-67) covering alternative investments.
Introduction to Alternative Investments
The reading really focuses on the commonalities of alternative investments and how they differ from traditional bonds/stocks. You’ll get more detail into each type of alternative in the other two exams.
Understand the five common characteristics of alternatives:
- Illiquidity – do not have as many buyers or open market transactions so may have to offer a premium
- Lack of current market value – because of illiquidity, transactions are not continuous and the current value may need to be estimated
- Data limitations – less risk and return data may be available because of infrequent trading
- Asymmetric information – valuations may differ greatly depending on geographic characteristics and there may be considerable information asymmetries
- Difficulty of analysis – since market transactions are less frequent and data limitations are higher the analysis work may be more difficult and have a lower degree of confidence
Understand the forms of real estate investment and advantages/limitations to each. Direct ownership can be prohibitively expensive and transaction costs are high but it is the most directly tied to prices. An indirect investment in equity or mortgages may have less transaction costs and limited liability. REITs are a hybrid between stock and real estate ownership that carry tax-advantages.
Remember the basic components of the NOI approach to real estate valuation and be able to do a calculation. Gross rental income minus vacancy or collection losses is the effective gross income. The effective gross minus (utilities, taxes, insurance, maintenance, management and advertising) equals the NOI.
Venture capital firms raise funds to invest in private companies or investments. The timeline is probably the most important material here but also understand some of the additional limitations and characteristics. The investment stages are broken into two groups: Formative stage (seed, startup, and first stage financing) and Later-stage (second stage, third stage, mezzanine, and IPO financing). Understand which stage of the production process coincides with each stage.
Hedge funds use a group of strategies for absolute returns, often through hedging or leverage. Understand the basic idea behind the most common strategies: long/short, market neutral, arbitrage, global macro, and event driven. Hedge funds normally charge a percentage of assets fee and an incentive fee of a percentage of profits over a benchmark return. Funds of funds are a single mutual fund or ETF that invests in hedge fund for smaller investors but has the disadvantage of adding another layer of fees.
Understand the problems in hedge fund performance measurement: self-selection, survivorship, smoothed pricing, option-like strategies, and fee structure gaming.
Investing in Commodities
The concept of backwardation and contango often seems to get candidates. The interplay between producers and other participants in the market can cause the future price of a commodity to be higher or lower than its spot. Generally, the future or forward price is lower than the spot (backwardation) because of carrying costs and is referred to as natural backwardation. Producers are willing to sell their expected inventory forward to lock in a price at the end of the season.
When prices are volatile, contango may occur where the future or forward price is above the spot price. This occurs because commodity buyers come into the market to hedge their future price risk.
The actual formula for cost-of-carry is not as important as the theory and the costs that go into it. The idea puts a theoretical max price on commodities referred to as ‘full carry’ and includes storage, insurance, transportation and financing costs.
Understand the three sources of return: collateral yield, roll yield and price return. Roll yield is not related to changes in the spot price but the return derived from selling expiring contracts and buying into longer dated contracts. The roll yield is positive for an investor in backwardation.
Beyond the first section, the commodities reading is largely conceptual and some fairly easy material. Understand the controversy around commodities as an asset class (i.e. do not generate cash flows, return may result from rebalancing instead of increase in asset price, roll yield may disappear). Also, understand the general principal behind the two types of commodity investment approaches: index funds and index-plus strategy.
An index fund involves buying an ETF or an index swap for exposure while the index-plus strategy may involve a collateral return strategy, roll management, rebalancing, or maturity management.
We’ve made it through each of the study sessions. Hopefully, you’ve been able to keep up and do practice problems and review for each topic as well as the readings.
‘til next time, happy studyin’
Joseph Hogue, CFA