Alternative Investments Overview
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Questions and Answers

What is the primary purpose of 12b-1 fees?

  • To cover the costs of distributing and selling mutual fund shares. (correct)
  • To cover the costs of regulatory compliance.
  • To cover the costs of fund management.
  • To compensate fund managers for their performance.

    • What is the 'two and twenty' rule in the context of hedge funds?

  • A rule that limits the amount of leverage hedge funds can use.
  • A guideline that limits the types of investments hedge funds can make.
  • A regulation that requires hedge funds to disclose their investment strategies.
  • A standard fee structure that charges 2% annually and 20% of profits. (correct)

    • What is the purpose of the high-water mark provision in hedge fund management fees?

  • To incentivize managers to take on more risk.
  • To prevent managers from being paid for poor performance. (correct)
  • To limit the amount of fees that managers can charge.
  • To ensure that investors receive a minimum return on their investment.

    • Which of the following is NOT a common hedge fund strategy?

    <p>Value Investing Strategy (C)</p> Signup and view all the answers

    What is a leveraged buy-out (LBO) in the context of private equity?

    <p>A strategy where a private equity firm acquires a company using a significant amount of debt. (C)</p> Signup and view all the answers

    What is the main purpose of a Hedge Fund?

    <p>To generate high returns for a select group of investors. (D)</p> Signup and view all the answers

    What is the role of the general partner in a hedge fund?

    <p>They are responsible for managing the fund and making investment decisions. (C)</p> Signup and view all the answers

    Which of the following investment strategies is NOT typically associated with hedge funds?

    <p>Index Tracking (B)</p> Signup and view all the answers

    What is the total value of the investor's original investment after the fund earns a 15% return?

    <p>$575,000 (B)</p> Signup and view all the answers

    What amount does the investor owe to the portfolio manager after the first month?

    <p>$15,000 (B)</p> Signup and view all the answers

    Which statement best describes the purpose of a hurdle rate in the context of hedge funds?

    <p>It determines the minimum return required before incentive fees are charged. (C)</p> Signup and view all the answers

    What must happen before a hedge fund can charge an incentive fee if it has both a high-water mark and a hurdle rate?

    <p>Returns must exceed the hurdle rate and the fund's value must be above the high-water mark. (D)</p> Signup and view all the answers

    In what circumstance can a clawback provision be applied in a company's contract?

    <p>When evidence of fraud or misuse of information is found. (C)</p> Signup and view all the answers

    Which characteristic makes REITs appealing for portfolio diversification?

    <p>Low correlation with other assets (D)</p> Signup and view all the answers

    What is a key benefit of investing in REITs regarding dividend payouts?

    <p>REITs must distribute at least 90% of profits as dividends (C)</p> Signup and view all the answers

    What is one of the main risks associated with investing in alt funds?

    <p>Low liquidity (C)</p> Signup and view all the answers

    How do REITs allow individual investors to gain exposure to real estate?

    <p>By pooling capital for real estate projects (A)</p> Signup and view all the answers

    What is a significant disadvantage of mutual funds compared to alt funds?

    <p>Difficult to value (A)</p> Signup and view all the answers

    Which type of funds primarily consists of a pool of money collected from many investors?

    <p>Mutual Funds (A)</p> Signup and view all the answers

    What does the SEC's regulation of alt funds mostly ensure?

    <p>Investor protection and transparency (A)</p> Signup and view all the answers

    What is a notable risk associated with investing in hedge funds compared to conventional mutual funds?

    <p>Lower regulatory oversight (D)</p> Signup and view all the answers

    What is a primary feature of a REIT's financial structure?

    <p>It follows standard rules for public disclosures. (C)</p> Signup and view all the answers

    What type of capital do Private Equity firms mainly provide?

    <p>Patient capital for longer-term investments. (D)</p> Signup and view all the answers

    What is a common structure for Private Equity funds?

    <p>Limited partnerships. (D)</p> Signup and view all the answers

    Which of the following is NOT typically a focus of Private Equity firms?

    <p>Investing predominantly in mutual funds. (C)</p> Signup and view all the answers

    How do REIT units react to market changes?

    <p>They are priced daily based on market sentiment. (A)</p> Signup and view all the answers

    What challenge might Public sector companies face that PE firms can address?

    <p>Outdated business philosophies and operational inefficiencies. (D)</p> Signup and view all the answers

    What characterizes the lifecycle of a Private Equity fund?

    <p>They typically span a finite period of 7-12 years. (D)</p> Signup and view all the answers

    What do Private Equity firms commonly charge their investors?

    <p>Management fees around 2% and performance fees of 20% on profits. (D)</p> Signup and view all the answers

    What is the primary reason why alternative investments are often considered suitable for portfolio diversification?

    <p>They typically have low correlation with traditional asset classes. (C)</p> Signup and view all the answers

    What is the main factor that distinguishes alternative investments from traditional investments?

    <p>Alternative investments are not regulated by the Securities and Exchange Commission (SEC). (C)</p> Signup and view all the answers

    What is a benefit of alternative investments for investors looking to hedge against inflation?

    <p>They often consist of tangible assets, such as gold and real estate, which can retain value during periods of inflation. (A)</p> Signup and view all the answers

    What is a common characteristic of alternative investments that makes them less accessible to retail investors compared to conventional investments?

    <p>Alternative investments often have higher minimum investment requirements and fees. (C)</p> Signup and view all the answers

    Which of these is NOT considered an alternative investment?

    <p>Government bonds (A)</p> Signup and view all the answers

    What is a key advantage of alternative investments, particularly in relation to their correlation with traditional asset classes?

    <p>They have low correlation with traditional assets, offering diversification benefits. (D)</p> Signup and view all the answers

    What aspect of alternative investments makes them particularly challenging for retail investors?

    <p>Their lack of transparency and regulation can make assessing their risk and performance difficult. (C)</p> Signup and view all the answers

    What is the primary reason why transaction costs for alternative investments are typically lower than those of conventional investments?

    <p>They are less frequently traded, resulting in lower turnover. (D)</p> Signup and view all the answers

    Flashcards

    Leveraged Buy-Out (LBO)

    A transaction where private equity funds buy a company using a combination of equity and debt.

    Hedge Fund

    A private investment fund that employs various strategies to earn high returns for accredited investors.

    Long/Short Equity Strategy

    An investment strategy that involves buying stocks expected to rise and short-selling stocks expected to fall.

    12b-1 Fees

    Fees deducted from mutual fund/ETF assets for marketing and shareholder services.

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    Two and Twenty Rule

    The standard fee structure for hedge funds: 2% annual fee and 20% performance fee.

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    High Water Mark Provision

    The highest value an investment fund reaches, ensuring manager fees reflect performance increases.

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    Market Neutral Strategy

    An approach that aims to eliminate market risk by taking offsetting long and short positions.

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    Event-Driven Strategy

    Investment strategy focused on events like mergers or acquisitions that can affect stock prices.

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    Alternative Investment

    A financial asset not classified as equity, fixed income, or cash.

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    Examples of Alternative Investments

    Private equity, hedge funds, commodities, real property, and tangible assets.

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    Regulation of Alternative Investments

    Most are unregulated by the SEC and can be illiquid.

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    Investor Types

    Alternative investments are typically held by institutional and accredited investors.

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    Transaction Costs

    Generally lower than those for conventional assets due to lower turnover.

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    Correlation with Standard Asset Classes

    Alternative investments have low correlation with stocks and bonds.

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    Hedge Against Inflation

    Investing in hard assets like gold and real estate helps protect purchasing power.

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    Accessibility for Retail Investors

    Alternative mutual funds and ETFs make these investments accessible to non-accredited investors.

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    Alt Funds

    Alternative funds that are SEC-registered and regulated.

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    Pros of Alt Funds

    Benefits include high rewards, inflation hedge, and diversification.

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    Cons of Alt Funds

    Challenges include high risk, illiquidity, and difficulty in valuation.

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    Mutual Funds

    Pooled money from investors managed to buy stocks and bonds.

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    REIT

    Real Estate Investment Trust; a company providing regular income from real estate.

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    Benefits of REITs

    Includes diversification, regular income, and tax exemptions for dividends.

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    Dividend Payout in REITs

    REITs must distribute at least 90% of profits as dividends to remain tax-exempt.

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    Debt-Free Investment in REITs

    REITs are equity financed, with only unsecured borrowing allowed.

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    REIT Structure

    A REIT operates with no debt, minimizing cash flow distress and default risks.

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    REIT Transparency

    REITs must disclose information similarly to public companies, ensuring transparency.

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    REIT Liquidity

    REITs are listed on stock exchanges, allowing investors to exit at any time.

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    Private Equity (PE)

    PE involves investing in companies using patient capital with a typical lifespan of 7-12 years.

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    PE Investment Strategies

    PE firms employ various strategies like buyouts, PIPE investments, and expansion capital.

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    PE Support

    PE firms offer resources, guidance, and operational improvements to help companies grow.

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    PE Fund Structure

    PE funds are typically set up as limited partnerships, involving general and limited partners.

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    PE Fee Structure

    PE firms charge a 2% management fee and a 20% performance fee on profits.

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    High-Water Mark

    The highest value reached by an investor's investment before fees are deducted.

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    Hurdle Rate

    The minimum return a hedge fund must achieve before charging incentive fees.

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    Incentive Fee

    A fee charged by hedge funds based on the performance exceeding a specified return.

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    Clawback Provision

    A contractual agreement requiring previously paid money to be returned under certain conditions.

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    Portfolio Management Fee

    A fee charged by portfolio managers based on the investment's performance or assets.

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    Study Notes

    Alternative Investments

    • Alternative investments are financial assets that do not fall into conventional equity, fixed income, or cash categories.
    • Examples include private equity, venture capital, hedge funds, real property, commodities, and tangible assets.
    • Most alternative investments are not regulated by the SEC and tend to be illiquid.
    • Traditionally, these are for institutional and accredited investors, but access has increased for retail investors via alternative funds, ETFs, and mutual funds, REITs.

    Alternative Investment Characteristics

    • Most alternative investment assets are held by institutional investors or high-net-worth individuals due to their complex nature, lack of regulation, and degree of risk.
    • Many alternative investments come with high minimum investments and fees, especially compared to mutual funds and ETFs.
    • These investments often have less opportunity to publish verifiable performance data and advertise to potential investors.
    • While initial minimums and fees may be high, transaction costs are generally lower than conventional assets due to lower turnover levels.

    Alternative Investment Strategy

    • Alternative investments typically have a low correlation with standard asset classes.
    • This low correlation often means their returns move in the opposite direction of stock and bond markets.
    • This characteristic makes them suitable for portfolio diversification.
    • Investments in hard assets (gold, oil, real property) also function as hedges against inflation, safeguarding the purchasing power of paper money.

    Types of Alternative Investments

    • Mutual Funds: A pool of money from investors used by fund managers to buy stocks, bonds, or money market instruments to build a portfolio. These offer an advantage for avoiding the hectic and time-consuming process of individual stock selection and trading.
    • Open-End Funds: These funds have continuous offering, meaning shares can be created or redeemed at net asset value (NAV) on a regular basis. They occasionally have sales or redemption fees and ongoing management and distribution fees (12b-1 fees). They are priced at closing NAV and do not allow short sales.
    • Closed-End Funds: These funds have a fixed number of shares, often issued through an initial public offering (IPO). Shares trade like stocks and can be shorted or traded with margin. Share prices typically float at a premium or discount to NAV. Management fees are charged.
    • Exchange-Traded Funds (ETFs): Trade like closed-end fund shares mirroring an index. They typically have low fees, low turnover, and low tax liability, but cash redemptions by shareholders are discouraged. In-kind creation and redemptions maintain NAV close proximity.
    • Real Estate Investment Trusts (REITs): Companies owning or financing income-producing real estate. They are similar to mutual funds, providing investors with regular income streams, diversification, and long-term capital appreciation. Investors buy shares, earning income from rental or sale of the property.
    • Venture Capital: Investment in companies at early stages (seed, start-up, first, second, third stages, mezzanine). Stage funding depends on the company's maturity. Venture capital funding often involves long investment horizons and may be illiquid.
    • Private Equity: Patient capital for companies, contrasted with mutual funds' infinite lives. Typically structured as limited partnerships and often involve buyouts or expansion capital.
    • Hedge Funds: Skill-based investment strategies aiming for absolute returns regardless of market direction. These funds are private, have significant manager involvement, and often have complex structures and high fees (often a 2% annual fee and a 20% performance fee). Hedge funds typically pursue various investment strategies, including long/short equity, market-neutral, merger arbitrage, convertible arbitrage, capital structure arbitrage, fixed-income arbitrage, event-driven, and global macro strategies.
    • Distressed Securities Investing: Investment in companies near bankruptcy or in bankruptcy protection attempting to avoid bankruptcy through out-of-court debt restructuring. Illiquidity, long investment horizon, and heavy investor involvement are key characteristics.
    • Funds of Funds: Pool of hedge funds offering diversification and reduced risk, but with higher management fees which impact returns.

    Additional Characteristics, Pros and Cons

    • Liquidity: Most alternative assets are fairly illiquid, especially compared to their conventional counterparts.
    • Legal Structure: Alternative investments often have less clear legal structures compared to conventional investments, requiring extensive due diligence by investors.
    • Pros: counterweight to conventional assets, portfolio diversification, inflation hedge, high rewards
    • Cons: difficult to value, illiquidity, unregulated, high risk

    Investment Fundamentals: Short Selling and Margin Buying

    • Selling Short: The investor borrows stock first, sells it in the market, later repurchases the stock, and returns it to the lender. Profit/loss is difference between original selling and repurchase prices. Rules: Dividends and margin/collateral must be paid to the lender.
    • Buying Stock on Margin: The investor borrows part of the money needed to buy stock, often 50% at a minimum. The broker holds the stock as collateral. Margin requirement (currently 50%) is set by the Federal Reserve Board and needs to be met. Equity percentage is stock value - loan value.

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    Alternative Investments Lecture 2 PDF

    Description

    This quiz explores alternative investments, which are financial assets not typically classified under conventional categories like equity or fixed income. You'll learn about various types of alternative investments, their characteristics, and the investors who primarily participate in these markets. Gain insights into how access has evolved for retail investors through various financial products.

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