Traditional vs Alternative Investments PDF

**Traditional vs Alternative Investments** Commodities -- for example: gold, silver... Hedge funds has specific strategies of investment Managed futures can be treated as different type of hedge fund We can find different classifications. Remember which are traditional and remember that the new...

**Traditional vs Alternative Investments** Commodities -- for example: gold, silver... Hedge funds has specific strategies of investment Managed futures can be treated as different type of hedge fund We can find different classifications. Remember which are traditional and remember that the new versions are placed/ still connected to the old versions. Investing in hedge funds we invest in cash for example. Commodities feature: quick rise of prices and systematic fall. Traditional investments are the most liquid. Modern alternative investments are the least liquid. **Common features:** - Risk/return characteristics - Diversification - Illiquidity - Due diligence process **Alternative investors:** - High Net Worth Individuals - Pension Funds - Other institutional investors (insurers, foundations etc.) The risks and rewards of incorporating alternative investments into both individual and institutional portfolios **Alternative investments can be viewed as:** - Providing exposure to risk factors - Providing exposure to investments strategies (new ones, not accessible for individuals) - Combining both 1. Traditional investments - Beta return -- behavior of the whole market (market risk and premium) 2. Alternative investments -- Alpha return (excess return) return not dependent on market (?) **Alpha drivers:** - Absolute return strategies -- it will give you small return no matter if the market is high or down - Market segmentation (investing in different small subgroups f the market) -- you concentrate on one, particular submarket/subgroup - Concentrated portfolio -- it depends on the benchmark, if it is S&P 500 and you will choose investing in 500 companies it will be hard to bear this index, if you will choose 10 companies and you will choose them good there is high probability that you will beat the index. It is really important and work in reality -- be concentrated. - Nonlinear return distribution -- connected with derivatives, especially options. **Certain points to consider:** - Be outside of benchmark -- be enough courage to invest differently than other market participants - Mix asset classes - Not outperform peers in short/medium term -- have the best return in the long term - Be where you have the best information advantage -- focus on assets in which you are an expert **Institutional investors:** - Market - managers - Investment process - Serives providers - Organization - Documents **Individual investors:** - Tax issues -- in Poland simple risk policy but in US more complicated. Investing in some countries you have to pay tax only in investing country, but sometimes twice -- in ivesting country and your country. - Decision risk -- during crashes sometimes people are not able to make any decision, being frozen. Or People wait that price will be even lower to buy shares but the prices stop to fall and start to raise so they lost their chance. - Liquidity -- think what you need and adjust your investment to meet the liquidity factor - Suitability **Core -- satellite portfolio** Beta investment is a core, alternatives are satellites (different investments) **Structured products:** 1. **Credit Default Swap (CDS)** Swap transaction in which one party give sth and you giv sth to other party. Paying for sth Credit default mean problems with paying obligations. Buying CDS is buying insurance in case sth will go wrong with our investment. These are individually negotiated instruments. **Things to consider:** - Trigger events -- what have to happen to use the insurance, i.e. bankruptcy, delay in payment, restructuring process, breach the particular threshold (i.e. EBITDA is below certain level) - Settlement -- how the settlement is done when problems occurs -- full amount, part of our money etc. - Delivery -- money or another instrument instead of money **Risks**: - Counterparty -- credit protection seller also can bankrupt. - Liquidity -- when we decide to sell investments is wise to sell also insurance -- not that easy - Pricing -- not that easy to find logically priced offer - Operational 2. **Collateralized Debt Obligations (CDO)**  Special Purpose Vehicle founded by different sources buy from banks different kind debt obligations. From those obligations they create new instruments available for differently risk-focused investors. Senior bond the least risky, the mezzanine more risky and subordinated treated as an option. **Types of CDOs:** - Balance sheet - Arbitrage - Cash funded - Synthetic **Risks:** - Default of underlying instrument - We can have different debt instruments inside our newly created instrument, quality od underlying instrument - Downgrade of tranche **Hedge funds -- history** - Alfred Winslow Jones - 1949 first HF started - 1966 newspaper article - 1997 Asian Crisis - 2008 Lehman Brothers crisis HF performed worse during crisis than investors expected. Hedge fund vs traditional funds: **Traditional funds** **Hede funds** --------------------------------------------------- -------------------------------------- Benchmark returns -- market, index (beta returns) Absolute return (alpha returns) Traditional strategies Alternative strategies (flexibility) Passively managed Actively manager Scalable May be not scalable Traditional has a benchmark and it usually get the same rate of return as market -- in both directions, positive and negative effects. Hedge funds give maybe less but always positive return. Hedge funds are active investments, traditional are passive. HF are more risky but the ratio risk/return is usually better +-----------------------------------+-----------------------------------+ | **Traditional funds** | **Hede funds** | +===================================+===================================+ | Liquid | Illiquid | | | | | - Daily subscriptions & | - Subscription term (not that | | redemptions | easy to get into the HF) | | | | | | - Lock-up period (different | | | periods, you cannot take your | | | money back (?)) | | | | | | - Gate for redemption | | | (wykupienie) (not every day, | | | only when HF give you this | | | opportunity) | +-----------------------------------+-----------------------------------+ | Fee | Fee | | | | | - Management fee (Regardless of | - Management fee (also take | | the result) | management fee and the levels | | | are more or less similar) | | | | | | - Performance fee (can be | | | stated in different ways, is | | | paid only if the rate of | | | return is good enough) | | | | | | - Hurdle rate (rate of return | | | that HF have to obtain to get | | | performance fee) | | | | | | - High water mark (if the HF | | | has looses first it has to | | | cover them and then can think | | | about the performance fee) | +-----------------------------------+-----------------------------------+ **High water mark:** +-----------------------------------+-----------------------------------+ | **Traditional funds** | **Hede funds** | +===================================+===================================+ | **Simple legal structure** | **Different legal structures** | | | | | | (HF are like private companies so | | | the structures can be different | | | but are also regulated ) | +-----------------------------------+-----------------------------------+ | **Full transparency** | **Limited transparency** | | | | | (have to create particular | it increased but is still low. | | documents and so on) | Usually are forbidden to | | | marketing themselves to | | | individual investors. It is not | | | that easy to even find the HF or | | | info about it. We know only what | | | the HF want to we know about it. | +-----------------------------------+-----------------------------------+ | **Investment managers** | **Investment managers and | | | partners** | | | | | | Investment managers also invest | | | their money in the fund so they | | | have double investment there. | +-----------------------------------+-----------------------------------+ | **Target investors: individuals** | **Target investors:** | | | | | | - Institutions | | | | | | - High Net Worth Individuals | | | (HNWI) | | | | | | First only HNWI were interested | | | in but after seeing returns and | | | implementation of regulations | | | also institutions started to be | | | interested. | | | | | | HNWI -- rich enough to loose and | | | then make up the looses. Also the | | | most-risky investments seeker. | | | Institutions mean high money | | | inflow and one institution going | | | into encourage next institution. | +-----------------------------------+-----------------------------------+ **Risk measures -- maximum drawdown** Standard deviation is the most often used. But for investment it not give us the useful information. Maximum drawdown -- the difference between the highest and the lowest. We can calculate only one maximum drawdown and more drawdowns. Obraz zawierający tekst, zrzut ekranu, diagram, Czcionka Opis wygenerowany automatycznie **HF strategies -- long/short equity** Still one of the main HF strategy but it depends on the market Net exposure -- difference between long and short **Sources of return:** - Spread between long and short positions - Interest on the short sold shares - Spread in dividends **Investment approaches** - How to choose long and short positions: - Valuation based -- most classic, very popular - Sector based -- which sector is undervalued/overvalued- short position in case of overvalued, long undervalued. - Quantitative based -- only on numbers and data sets -- we create for example rankings based on numbers, we do not consider individual valuation - Activist strategies -- venture/private capital **Disadvantages** - Higher trading cost -- long and short positions, frequent changes - Higher turnover -- it not usually give you improvement of risk/return ratio - Lag in bull markets -- In bull market this strategy will be always lower than broad market - Net long bias -- long positions are usually bigger than short. When the market Is going down we should not expect from strategy that it will not be the loss. **HF strategies -- equity market neutral** - Similar to the long/short equity The general idea it to get positive return whenever the market is going up or down. - Market neutrality: - Dollar neutral -- nominal value of the short and long position is the same. But if it is possible? It is very rare to give as whole neutrality. It is hard to get assets that will behave perfectly in the opposite directions. - Beta neutral -- average beta of the whole portfolio is zero -- we are not correlated with the market at all but ofc it is not that easy. Beta changes in time. - Sector neutral -- portfolio constructed is neutral to the sector. - Factor neutral -- neutral to particular factors- for example raising interest rates. Choose long and short from stocks most impacted by changing interest rates. Most successful but hard to build for individuals. **Strategies:** - Pairs trading (concentrated portfolio -- necessary, up to 40/50 positions in the portfolio) Buy one share and sell short the another share. Can be done within one sector or different sectors. Impact on fundamental approach -- know the companies - Statistical arbitrage Based only on numbers (market data -- different factors) We do rankings/model which give answer what to buy and what to say. Focus on numbers, not fundamental approach. Diversified portfolio, game of probabilities. Done by HF or investments banks, not individuals. - HFT (renaissance technologies) -- trading with a very small time frame -- high frequency. LOOOOT of transaction. Not about investing, it is about trading. Renaissance technologies (name of the HF) the most renown from this strategy. It has unbelievable high rate of return, beat the market. Earning the most when there is crisis on the market. They are focused on numbers and algorithms. What about the results of this strategies? It is true that those are earning even if the crash on the market. Very few drawdowns and not that hard as on the market or fat return. From statistics -- maximum drawdown only about 5.5% - very small. Percentage of positive months -- 76% (a lot) This strategy is for people who look for investment immune to the changes on the market, playing safe. (least impacted by the general market). **Distressed (zbuożały) securities** (equities and debts) Debt: - Listed on stock exchanges - Private (not as in market neutrality or long/short) Equities: - Listed - Private Connected with the ratings.  TOP part of the table (low risk that they will not repay their debts so the price is also higher) LOW part of the table -- junk box/instruments. **Opportunities:** Why to invest in sth in which is high probability that sth will go wrong? Ofc the price is low but if everything will go well the return is high. - Excess selling pressure If the fund strategy is to have in portfolio assets rated 3B or higher they will immediately sell instrument which was downgraded and thus the price will decrease. Polish example: LPP was accused of lying by one magazine, that day stock price dropped down by more than 30%. Those people who buy stocks that day earned money later because the price came back to the previous level. This is the strategy -- to find those kind of events. - Restructuring process There is a lot of examples of making a lot of money if the restructuring process turned out to be successful. - Assets cherry picking -- only on US market If you are holder of debt instrument of one company and it company is in trouble and is not paying you money back you are asking to get particular assets instead. **Strategies:** - Passive -- buy the shares and wait for the results - Active -- buy and actively try to help the company (being for example in restructuring process) **Risks**: - Financial (recovery rate, time) -- we are not sure that we will earn, if yes we do not know how much and when - Long bias -- it is not have sense to take shot position here - Liquidation -- maybe restructuring process won't be successful and it will be liquidated - Liquidity -- it might be not that easy to sell instruments, no one will want to buy the shares - Law: - Insider trading -- in case of active strategy, when you have non public information, do not use it and be careful because you can be accused of insider trading - Taxes - in Poland tax law is quite clear, but it differ in countries and especially it is complicated in US - Judge factor -- US, UK, Australia -- judge is the most important person **Results:** This strategy has drawdowns and also flat returns periods Return close to market return Maximum drawdown is a lot Percentage of positive months -- usually you are making money **HF strategies -- global macro** Very diversified group but with: - Global nature of strategies -- it uses different instruments from different markets - Focus on structural macroeconomics trends/imbalances -- not on particular bonds/shares, rather on macrosector trends It invest not in particular stocks, it invest mostly in indexes. In the past it was based mostly on derivatives, nowadays it is easy to do using ETF (fundusz inteksowy). More ETFs are without leverage so you can do it with less risk than in derivatives case. **Possible approaches:** - Feedback based -- exploiting market psychology -- investor is looking for market participants approaches - Model based -- market expectations vs model estimates -- it is feedback based approach + information from model - Information based -- data collection and analysis -- based only on data, without quality factors **Results:** Drawbacks are quite small, after covid return is flat. It is quite save strategy. Can be buy by individuals but required regular observation. Example: polish monetary but said that will not cut interest rates in 2024 a and 2025, US FED said that they will be so dollar will be weaker and Zloty will be stronger so the strategy is to buy polish zloty instead of dollars. **HF strategies -- managed futures/commodity trading advisors (CTA)** - Broad group of different strategies based on futures - Algorithmic approach -- manager only creates algorithm History: in US market derivatives become popular (mainly futures) and some people became specialists in trading derivatives on behalf of different investors. Why based on futures? Trading futures on different assets (currencies, bonds..) **Trading approaches:** - Systematic -- analyzing big sets of data - Discretionary -- more quality analysis, not only numbers - Mixed -- combined both **Analysis:** - Fundamental -- doing some kind evaluation (qualitative for example) - Technical -- historically this analysis was very important - Mixed **Time:** - Short term -- a lot within few seconds - Medium term -- transactions in minutes/days - Long term -- weeks/years Most probable short and medium. **Returns**: either first or the second, approaches are completely different, not combining both - Trend following - Contrarian (przeciwnik przeważającej opinii) **Returns:** Line is not smooth, is changing (up's and down's but without big drawdowns), long periods being flat **HF strategies -- emerging (powstający, kształtujący się) markets** - Growth potentials: - Equity -- buying shares/stocks - Debt Caution! Even if the potential is high there is also high risk - Risks: - Volatility -- much higher - Low liquidity -- it is harder to get a position and overall to invest in this market, for example you have to work in cooperation with local broker and also some instruments are available only for local investors - Inefficiency -- both sides: we can earn more but we can wait very long Caution! Even if the potential is high there is also high risk **HF strategies-- merger/risk arbitrage** - Taking profit from merger/takeover transactions: - Buying targets - Buying targets/selling bidders - Merger/takeover waves Obraz zawierający tekst, Czcionka, zrzut ekranu, linia Opis wygenerowany automatycznie - Transaction risk: unsuccessful takeover - Bidders attitude/target management attitude - Type of deal - Premium offered - Shareholder structure - Buying actual or potential merger targets - Anti-trust law - Economic condition - Market trend - Calendar risk **HF strategies-- convertible arbitrage** - Taking profit from inefficiences in valuations of convertible bonds - Convertible bonds issued often below their fair value - Convertible bond = straight bond + equity option - Convertible bonds: - Distressed-- stock price much lower than conversion price. Risk of default. - Busted-- conversion unlikely due to low stock price but no default risk - Hybrid-- stock price close to conversion price, option at the money - Equity -- stock price much higher than conversion price - Simple strategy: - Buy convertible bond below fair value. Hedge risks by selling short shares and interest rate futures/swaps - Needs rebalancing **Risks**: - Interest rate - Credit - Equity - Liquidity - Other (event, specific) **HF strategies -- fixed income arbitrage** Investment styles: - Relative value - Market neutral - Directional **HF strategies-- fund of hedge funds** Advantages: - Diversification - Affordability&accessibility - Professional management - Access to funds - Better tranparency Disadvantages: Fees - Extra liquidity - Lack of control - Duplication **HF databases&indicies** - No one global database - Differences: - Geography - Numberof funds - Problems: - Self selection bias - Sample selection bias - Survivorship bias - Backfill bias - Infrequent pricing **HF indicies:** Keyfactors: - Transparency - Index coverage - Weighting - Investability - Timely reporting - Stability of performance **HF benefits** - Positive risk/return statistics - Lowcorrelation with traditional markets (with some exceptions ie. EM strategies) **HF selection** 1. Investor objectives and constraints - Strategy - Tax efficiency - Size - Redemption (wykupienie) 3. First screening 4. Potential candidates quantitative and qualitative analysis - Returns and risks in numbers - Consistency 5. Short list of possible hedge funds 6. Due diligence **HF due diligence:** 1. Strategy: - Changes in time - Examples of trades (with gains and losses) - Managers&strategy - Limits - Leverage, concentration, liquidity - Competition 2\. Hedge fund 3\. Management team 4\. Infrastructure 5\. Investment process **HF case study- LTCM** **Lessons from the LTCM case:** - Too much leverage is always a bad idea - Underestimating the price of liquidity and best quality assets