Alternative Investments

DR. 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. DR. HOSSEIN KAZEMI, PhD, is a senior adviser to the CAIA Association. He is the Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts, Amherst; Director of the Center for International Securities and Derivatives Markets; a cofounder of the CAIA Association; and Editor-in-Chief of The Journal of Alternative Investments—the official publication of the CAIA Association and a member of the editorial board of The Journal of Financial Data Science. DR. KEITH H. BLACK, PhD, CAIA, FDP, is the Managing Director of Content Strategy at the CAIA Association. He was previously an associate at Ennis Knupp and, before that, an assistant professor at Illinois Institute of Technology. He is a member of the editorial board of The Journal of Alternative Investments.

• Preface xxxixAcknowlegements xliAbout the Authors xlvPart 1 Ethics Regulations and ESGChapter 1 Asset Manager Code 31.1 General Principles of Conduct 31.2 Asset Manager Code 31.3 Notification of Compliance 51.4 Additional Guidance for the Asset Manager Code 6Chapter 2 Recommendations and Guidance 11Chapter 3 Global Regulation 273.1 Overview of Financial Market Regulation 273.2 Regulation of Alternative Investments Within the United States 283.3 Alternative Investment Regulation in Europe 383.4 Hedge Fund Regulation in Asia 45Chapter 4 ESG and Alternative Investments 494.1 Background on ESG and Alternative Investing 494.2 ESG and Real Assets: Natural Resources 514.3 ESG and Real Assets: Commodities 534.4 ESG and Real Assets: Real Estate 554.5 ESG and Hedge Funds 614.6 ESG and Private Equity 66Chapter 5 ESG Analysis and Application 715.1 Background on ESG 715.2 ESG Ratings and Scores 735.3 ESG Materiality and Disclosure 745.4 The United Nations Role in ESG Issues 765.5 ESG Fiduciary Responsibilities and Regulation 785.6 Methods of ESG Investing 805.7 Market-Based Methods of Addressing ESG Issues 855.8 ESG and Special Investment Consideration 87Part 2 ModelsChapter 6 Modeling Overview and Interest Rate Models 936.1 Types of Models Underlying Investment Strategies 936.2 Equilibrium Fixed-Income Models 966.3 Arbitrage-Free Models of the Term Structure 996.4 The Black–Derman–Toy Model 1006.5 P-Measures and Q-Measures 103Chapter 7 Credit Risk Models 1057.1 The Economics of Credit Risk 1057.2 Overview of Credit Risk Modeling 1097.3 The Merton Model 1107.4 Other Structural Models: KMV 1177.5 Reduced-Form Models 1207.6 Empirical Credit Models 123Chapter 8 Multi-Factor Equity Pricing Models 1278.1 Multi-Factor Asset Pricing Models 1278.2 FAMA–French Models 1318.3 Three Challenges of Empirical Multi-Factor Models 1338.4 Factor Investing 1358.5 The Adaptive Markets Hypothesis 1418.6 Time-Varying Volatility 1428.7 Stochastic Discount Factors 1438.8 Summary of Multiple-Factor Asset Allocation 145Chapter 9 Asset Allocation Processes and the Mean-Variance Model 1479.1 Asset Allocation Processes and the Mean-Variance Model 1479.2 Implementation of Mean-Variance Optimization 1559.3 Mean-Variance Optimization with Multiple Risky Assets 1609.4 Mean-Variance Optimization and Hurdle Rates 1629.5 Issues in Using Optimization for Portfolio Selection 1639.6 Adjustment of the Mean-Variance Approach for Illiquidity 1669.7 Adjustment of the Mean-Variance Approach for Factor Exposure 1689.8 Mitigating Estimation Error Risk in Mean-Variance Optimization 168Chapter 10 Other Asset Allocation Approaches 17510.1 The Core–Satellite Approach 17510.2 Top-Down and Bottom-Up Asset Allocation Approaches 17610.3 Risk Budgeting 17810.4 A Factor-Based Example of Implementing A Risk Budgeting Approach 18110.5 Risk Parity 18310.6 Other Quantitative Portfolio Allocation Strategies 18910.7 The New Investment Model 193Part 3 Institutional Asset Owners and Investment PoliciesChapter 11 Types of Asset Owners and the Investment Policy Statement 19711.1 Endowments and Foundations 19711.2 Pension Funds 19811.3 Sovereign Wealth Funds 19911.4 Family Offices 19911.5 Strategic Asset Allocation: Risk and Return 19911.6 Asset Allocation Objectives 20211.7 Investment Policy Constraints 20211.8 Investment Policy Statements for Institutional Asset Owners 204Chapter 12 Foundations and the Endowment Model 22112.1 Defining Endowments and Foundations 22112.2 Intergenerational Equity, Inflation, and Spending Challenges 22412.3 The Endowment Model 22612.4 Why Might Large Endowments Outperform? 22812.5 Risks of the Endowment Model 23412.6 Liquidity Rebalancing and Tactical Asset Allocation 23912.7 Tail Risk 24012.8 Conclusion 242Chapter 13 Pension Fund Portfolio Management 24513.1 Development, Motivations, and Types of Pension Plans 24513.2 Risk Tolerance and Asset Allocation 24713.3 Defined Benefit Plans 25113.4 Governmental Social Security Plans 25813.5 Contrasting Defined Benefit and Contribution Plans 25913.6 Annuities for Retirement Income 26213.7 Conclusion 266Chapter 14 Sovereign Wealth Funds 26914.1 Sources of Sovereign Wealth 26914.2 Four Types of Sovereign Wealth Funds 27214.3 Establishment and Management of Sovereign Wealth Funds 27414.4 Governance and Political Risks of SWFs 27714.5 Analysis of Three Sovereign Wealth Funds 27914.6 Conclusion 282Chapter 15 Family Offices and the Family Office Model 28515.1 Identifying Family Offices 28515.2 Goals, Benefits, and Business Models of Family Offices 28615.3 Family Office Goals by Generations 29015.4 Macroeconomic Exposures of Family Offices 29515.5 Income Taxes of Family Offices 29715.6 Lifestyle Assets of Family Offices 30015.7 Family Office Governance 30415.8 Charity, Philanthropy, and Impact Investing 30715.9 Ten Competitive Advantages of Family Offices 310Part 4 Risk and Risk ManagementChapter 16 Cases in Tail Risk 31516.1 Problems Driven by Market Losses 31516.2 Trading Technology and Financial Crises 32416.3 Failures Driven by Fraud 32616.4 Four Major lessons From cases in Tail Events 334Chapter 17 Benchmarking and Performance Attribution 33717.1 Benchmarking and Performance Attribution Overview 33717.2 Single-Factor Benchmarking and Performance Attribution 34017.3 Multi-Factor Benchmarking 34417.4 Distinctions Regarding Alternative Asset Benchmarking 34617.5 Benchmarking of Commodities 34817.6 Three Approaches to Benchmarking Managed Futures Funds 35117.7 Benchmarking Private Equity Funds 35217.8 Group Peer Returns as Benchmarks 35717.9 Benchmarking Real Estate 358Chapter 18 Liquidity and Funding Risks 36318.1 Margin Accounts and Collateral Management 36318.2 Value at Risk for Managed Futures 36718.3 Other Methods of Estimating Liquidity Needs 36918.4 Smoothed Returns on Illiquid Funds 37318.5 Modeling Price and Return Smoothing 37518.6 Unsmoothing a Hypothetical Return Series 37818.7 Unsmoothing Actual Real Estate Return Data 380Chapter 19 Hedging, Rebalancing, and Monitoring 38919.1 Managing Alpha and Systematic Risk 38919.2 Managing the Risk of a Portfolio with Options 39119.3 Delta-Hedging of Option Positions 39419.4 Three Key Observations on Delta-Hedging 39919.5 Three Observations on Rebalancing Delta-Neutral Option Portfolios 40019.6 Rebalancing Portfolios with Directional Exposures 40119.7 Mean-Reversion and Diversification Return 40719.8 Investment Monitoring 409Chapter 20 Risk Measurement, Risk Management, and Risk Systems 41320.1 Overview of Risk Measurement and Aggregation 41320.2 Categories of Information to be Considered 42220.3 Risk Measurement with Daily Frequency of Data Collection 42420.4 Risk Measurement with Weekly Frequency of Data Collection 42520.5 Risk Measurement with Monthly Frequency of Data Collection 42620.6 Risk Measurement with Quarterly Frequency of Data Collection 42720.7 Risk Measurement with Annual Frequency of Data Collection or Rolling Time Periods 42720.8 Cybersecurity for Fund Managers 42920.9 Risk Management Structure and Process 432Part 5 Methods for Alternative InvestingChapter 21 Valuation and Hedging Using Binomial Trees 43921.1 A One-Period Binomial Tree and Risk-Neutral Modeling 43921.2 Multi-Period Binomial Trees, Values, and Mean Rates 44221.3 Valuation of Convertible Securities with a Binomial Tree Model 44521.4 Valuing Callable Bonds with a Tree Model 45221.5 Tree Models, Visualization, and Two Benefits to Spreadsheets 458Chapter 22 Directional Strategies and Methods 45922.1 Efficiently Inefficient Markets 45922.2 Technical Directional Strategies Overview 46022.3 Fundamental Directional Strategies 46722.4 Directional Strategies and Behavioral Finance 47322.5 Directional Trading and Factors 476Chapter 23 Multivariate Empirical Methods and Performance Persistence 47923.1 Statistical Factors and Principal Component Analysis 47923.2 Multi-Factor Models and Regression 48323.3 Partial Autocorrelations and Regression 48523.4 Three Dynamic Risk Exposure Models 48723.5 Two Approaches to Modeling Changing Correlation 48923.6 Four Multi-Factor Approaches to Understanding Returns 49323.7 Evidence on Fund Performance Persistence 496Chapter 24 Relative Value Methods 49924.1 Overview of Relative Value Methods 49924.2 Types of Pairs Trading and the Four Typical Steps 50224.3 Statistical Pairs Trading of Equities 50324.4 Pairs Trading in Commodity Markets Based on Spreads 506Chapter 25 Valuation Methods for Private Assets: The Case of Real Estate 51925.1 Depreciation Tax Shields 51925.2 Deferral of Taxation of Gains 52225.3 Comparing After-Tax Returns for Various Taxation Scenarios 52425.4 Transaction-Based Indices: Repeat-Sales 52925.5 Transaction-Based Indices: Hedonic 53225.6 Sample Bias and the Repeat-Sales and Hedonic-Price Methods 53525.7 Appraisal-Based Indices 53625.8 Noisy Pricing 537Part 6 Accessing Alternative InvestmentsChapter 26 Hedge Fund Replication 54326.1 An Overview of Replication Products 54326.2 Potential Benefits of Replication Products 54426.3 The Case for Hedge Fund Replication 54526.4 Unique Benefits of Replication Products 54926.5 Factor-Based Approach to Replication 55226.6 The Algorithmic (Bottom-Up) Approach 55826.7 Three Illustrations of the Algorithmic (Bottom-Up) Approach 558Chapter 27 Diversified Access to Hedge Funds 56527.1 Evidence Regarding Hedge Fund Risk and Returns 56527.2 Approaches to Accessing Hedge Funds 56927.3 Characteristics of Funds of Hedge Funds 57327.4 Fund of Hedge Funds Portfolio Construction 57727.5 Ways that Funds of Hedge Funds Can Add Value 58027.6 Investable Hedge Fund Indices 58427.7 Alternative Mutual Funds 585Chapter 28 Access to Real Estate and Commodities 58928.1 Unlisted Real Estate Funds 58928.2 Listed Real Estate Funds 59428.3 Commodities 59828.4 Commodity Trade Financing and Production Financing 60628.5 Leveraged and Option-Based Structured Commodity Exposures 60628.6 Key Concepts in Managing Commodity Exposure 609Chapter 29 Access Through Private Structures 61329.1 Overview of Issues in Private Versus Listed Investment Access 61329.2 Unlisted Manager–Investor Relationships 61629.3 Side Letters to Limited Partnership Agreements 61929.4 Co-Investments 62129.5 Cash Commitments and Illiquidity 62629.6 The Secondary Market for PE Partnerships 629Chapter 30 The Risk and Performance of Private and Listed Assets 63730.1 Evidence on an Illiquidity Premium from Listed Assets 63730.2 Private Versus Listed Real Performance: The Case of Real Estate 63930.3 Challenges with the PME Method to Evaluating Private Asset Performance 64130.4 Multiple Evaluation Tools 64830.5 IRR Aggregation Problems for Portfolios 65330.6 The Case Against Private Equity 65730.7 Two Propositions Regarding Access Through Private Versus Listed Structures 658Part 7 Due Diligence & Selecting ManagersChapter 31 Active Management and New Investments 66331.1 Tactical Asset Allocation 66331.2 The Fundamental Law of Active Management 66431.3 Costs of Actively Reallocating Across Alternative Investments 66731.4 Keys to a Successful Tactical Asset Allocation Process 67031.5 Adjusting Exposures to Illiquid Partnerships 67431.6 The Secondary Market for PE LP Interests 676Chapter 32 Selection of a Fund Manager 68332.1 The Importance of Fund Selection Across Managers Through Time 68332.2 The Relationship Life Cycle Between LPs and GPs 68332.3 Fund Return Persistence 68832.4 Moral Hazard, Adverse Selection, and the Holdup Problem in Fund Management 69432.5 Screening with Fundamental Questions 69432.6 Historical Performance Review 69832.7 Manager Selection and Deal Sourcing 70332.8 Fund Culture 70532.9 Decision-Making and Commitment and Manager Selection 706Chapter 33 Investment Process Due Diligence 70933.1 Overview of Investment Due Diligence 70933.2 The Investment Strategy or Mandate 71233.3 The Investment Implementation Process and its Risks 71533.4 Asset Custody and Valuation 71733.5 Risk Alert’s One Advantage and Six Observations on Third-Party Information 72333.6 Portfolio Risk Review 72533.7 Four Warning Indicators and Awareness Signals Regarding Investments 72933.8 Four Warning Indicators and Awareness Signals Regarding Risk Management 729Chapter 34 Operational Due Diligence 73134.1 Operations: Overview, Risks, and Remedies 73134.2 Four Key Operational Activities 73534.3 Analyzing Fund Cash Management and Movement 73734.4 Analyzing External Parties and Checking Principals 73934.5 Analyzing Fund Compliance 74334.6 Onsite Manager Visits 74734.7 Elements and Key Concerns of the Odd Process 74834.8 Information Technology and Meta Risks 74934.9 Funding, Applying, and Concluding ODD 750Chapter 35 Due Diligence of Terms and Business Activities 75535.1 Due Diligence Document Collection Process 75535.2 Fund Governance 75735.3 Structural Review of the Fund And Fund Manager 75835.4 Terms for Liquid Private Funds 76135.5 Terms for Illiquid Private Funds 76335.6 General Terms for Private Funds 76435.7 Private Placement Memorandum (PPM) 76535.8 Fund Fees and Expenses 76935.9 Private Fund Audited Financial Statement Review 77135.10 Business Activities, Continuity Planning, Disaster Recovery, and Insurance 773Part 8 Volatility and Complex StrategiesChapter 36 Volatility as a Factor Exposure 77936.1 Measures of Volatility 77936.2 Volatility and the Vegas, Gammas, and Thetas of Options 78136.3 Exposures to Volatility as a Factor 78536.4 Modeling Volatility Processes 79136.5 Implied Volatility Structures 794Chapter 37 Volatility, Correlation, and Dispersion Products and Strategies 79937.1 Common Option Strategies and their Volatility Exposures 79937.2 Volatility and Delta-Neutral Portfolios with Options 80337.3 Advanced Option-Based Volatility Strategies 80537.4 Variance-Based and Volatility-Based Derivative Products 80737.5 Correlation Swaps 81537.6 Dispersion Trades 81837.7 Summary and Common Themes of Volatility, Correlation, and Dispersion Trading 819Chapter 38 Complexity and Structured Products 82538.1 Uncertainty, Ambiguity, and Opacity 82538.2 Asset and Strategy Complexity 82738.3 Cases in Complexity and Perverse Incentives 82838.4 Asset-Based Lending 83138.5 Risks of Asset-Based Loans 83638.6 Asset-Backed Securities 838Chapter 39 Insurance-Linked Products and Hybrid Securities 84539.1 Nonlife ILS: Catastrophe Bonds 84539.2 Four Trigger Types of Cat Bonds 84739.3 Cat Bond Valuation, Performance, and Drawbacks 84939.4 Longevity and Mortality Risk-Related Products 85239.5 Life Insurance Settlements 85539.6 Overview of Viatical Settlements 85739.7 Hybrid Products: Mezzanine Debt 859Chapter 40 Complexity and the Case of Cross-Border Real Estate Investing 86540.1 Traditional View of Currency-Hedging for Cross-Border Real Estate Investing 86540.2 Fundamentals of Currency Risk And Hedging in Perfect Markets 87040.3 Currency Risk and Hedging of Alternative Investments 87340.4 Accessing Foreign Assets with Futures and Quanto Futures 87640.5 Overview of International Real Estate Investing 87940.6 Heterogenous Investment Taxation Across Jurisdictions 88140.7 Challenges to International Real Estate Investing 882Index 887

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