Chapter 21 - CSC.pdf

Alternative Investments: Strategies and Performance 21 CHAPTER OVERVIEW In this chapter you will learn about a variety of alternative investment strategies and performance measurement tools. You will also...

Alternative Investments: Strategies and Performance 21 CHAPTER OVERVIEW In this chapter you will learn about a variety of alternative investment strategies and performance measurement tools. You will also learn about a comprehensive due diligence process and finish with a brief discussion about the suitability of alternative strategies. LEARNING OBJECTIVES CONTENT AREAS 1 | Explain how the various types of alternative Alternative Investment Strategies strategies work, including those in the relative value, event-driven, and directional strategy classifications. 2 | Identify the strategies that are most likely to be used in alternative mutual funds. 3 | Discuss risk measures and risk-adjusted Alternative Strategy Fund Performance return measures to alternative strategy Measurement fund investments. 4 | Discuss benchmarking of alternative investment performance. 5 | Describe the due diligence process that Due Diligence and Suitability of Alternative should be conducted when contemplating Strategies investment in an alternative strategy fund. 6 | Identify the investor groups for whom liquid alts might be most suitable. © CANADIAN SECURITIES INSTITUTE 21 2 CANADIAN SECURITIES COURSE      VOLUME 2 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. absolute risk kurtosis convertible arbitrage strategy maximum drawdown directional strategies merger strategy distressed security strategy relative value strategies emerging markets alternative funds risk arbitrage strategy equity market-neutral strategy short bias strategy event-driven strategies long/short equity strategy fixed-income arbitrage strategy skew global macro strategy time to recovery high-yield bond strategy © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 3 INTRODUCTION In the previous chapter, we learned what the risks and benefits of alternative investments are. We also learned about their structure and how liquid alts and hedge funds compare with each other and with conventional mutual funds. The previous chapter also briefly highlighted that alternative strategies can be categorized as relative value, event-driven, and directional strategies. In this chapter, we discuss at length a variety of investment strategies that alternative strategy managers employ in each of the categories mentioned above. We will also discuss performance measures and examine the many questions that one can ask as part of a comprehensive due diligence process. ALTERNATIVE INVESTMENT STRATEGIES 1 | Explain how the various types of alternative strategies work, including those in the relative value, event-driven, and directional strategy classifications. 2 | Identify the strategies that are most likely to be used in alternative mutual funds. Alternative investment strategies can be broken down into three general categories listed in order of increasing expected return and risk: Relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related stocks, bonds, or derivatives. Alternative strategy funds using these strategies generally have low or no exposure to the underlying market direction. Event-driven strategies seek to profit from unique corporate structure events such as mergers, acquisitions, stock splits, and stock buybacks. Alternative strategy funds using event-driven strategies have medium exposure to the underlying market direction. Directional strategies bet on anticipated movements in the market prices of equity securities, debt securities, foreign currencies, and commodities. Alternative strategy funds using these strategies have high exposure to trends in the underlying market. Table 21.1 shows the three major categories of alternative strategy fund strategies and the specific strategies that fall within each category. Table 21.1 | Major Alternative Strategy Fund Categories Relative Value Strategies Event-Driven Strategies Directional Strategies (Low Exposure to (Medium Exposure to (High Exposure to Market Direction) Market Direction) Market Direction) Equity market-neutral Merger or risk arbitrage Long/short equity Convertible arbitrage Distressed securities Global macro Fixed-income arbitrage High-yield bonds Emerging markets Dedicated short bias Managed futures © CANADIAN SECURITIES INSTITUTE 21 4 CANADIAN SECURITIES COURSE      VOLUME 2 RELATIVE VALUE STRATEGIES As mentioned, relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related securities. Relative value strategies include equity market-neutral strategies (also called pairs trading), convertible arbitrage, and fixed-income arbitrage. EQUITY MARKET-NEUTRAL STRATEGIES An equity market-neutral strategy is designed to exploit inefficiencies and opportunities in the equity market by creating simultaneously long and short matched equity portfolios of approximately the same size. The goal is to generate returns that do not depend on the direction of the stock market. The expected performance of the strategy relies on the ability of the manager to analyze individual stocks or other exposures, such as industries, valuations, or countries, and select appropriate pairs (hence the term pairs trading). The goal is to have zero, or very low, beta (i.e., low directional exposure). As such, the expected return above the risk-free rate is entirely or mostly the alpha created from the manager’s performance. Well-designed equity market-neutral portfolios hedge out risks related to industry, sector, market capitalization, currency, and other exposures. Moderate leverage (generally less than two times capital) is typically used to enhance returns. EQUITY MARKET-NEUTRAL STRATEGY BREAKDOWN The following steps illustrate the typical process undertaken by an equity market-neutral investment manager in executing a pairs trade: 1. Review the proprietary fundamental valuation models of two companies to determine relative value opportunities between related equities that arise from mispricing. 2. Compile a list of potential trading pairs. 3. Examine the pairs in the context of the current and historical price-spread relationship between the two securities. 4. Choose the pairs the investment manager would like to initiate as trading pairs. 5. Execute the pairs trade. 6. Enter the initiated trade into a real-time portfolio management system, along with the target price spread at which the trade will be reversed to realize the target return. The decision as to which two securities will make up the pair is based on the degree of similarity between the business activities of the two companies. Typically, the companies would be head-to-head competitors with very similar business strategies. © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 5 EXAMPLE Equity Market-Neutral Strategy Raj, an investment manager, wishes to establish a pairs trade between the stocks of Royal Bank of Canada (RY) and Toronto Dominion Bank (TD), two Canadian companies with very similar business activities. Raj has determined through relative market valuation that the current market price spread between the two securities is incorrect and therefore offers a trading opportunity. Using fundamental valuation techniques, he concludes that a market price spread of less than $22.00 is attractive enough to initiate the trade. However, before initiating the trade, he must also determine the appropriate price spread at which to reverse the trade and potentially earn a profit. Based on his analysis, Raj believes that the maximum appropriate price spread between the two stocks is $28.00. Figure 21.1 provides the share price history for the two banks over the past three years. Figure 21.1 | Stock Price Comparison 115 105 95 Stock price (CAD$) 85 75 65 55 45 20 18 19 8 9 9 7 7 8 -18 -19 -17 c-1 c-1 c-1 p-1 p-1 p-1 r- r- r- Jun Jun Jun Ma Ma Ma De De De Se Se Se Royal Bank of Canada Toronto-Dominion Bank Source: adapted from Bloomberg © CANADIAN SECURITIES INSTITUTE 21 6 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Figure 21.2 shows the market price spread between the two stocks and provides the key data required to initiate the pairs trade. The target price spread was attained on November 1, 2018, and Raj initiated the trade by shorting TD and going long RY simultaneously. Figure 21.2 | Share Price-Spread History and Statistics Trade Initiation 36 Trade Reversal 34 32 Price Spread (CAD$/share) 30 28. 26 24 22 20 18 20 18 19 8 9 9 18 7 7 -18 -19 -17 c-1 c-1 c-1 p-1 p-1 r- r- r- p- Jun Jun Jun Ma Ma Ma De De De Se Se Se Share Price Spread Mean 1st Std. Dev. 2nd Std. Dev. Source: adapted from Bloomberg Based on fundamental analysis, Raj decides to initiate a pairs trade between RY and TD at a price spread of $22.00 or less, and to reverse the trade when the price spread is at least $28.00. He executes the trade with an investor’s capital amount of $740,000. The steps involved in the trade’s initiation and eventual reversal are as follows: 1. On November 1, 2018, the price spread between RY and TD was at or below the target price spread of $22.00. Accordingly, the trade is initiated at a price spread of $21.86 (shown in Table 21.2, Initiation section). Specifically, the trade initiation involves two simultaneous actions: a. Shorting $740,000 worth of TD stock (10,000 shares) b. Purchasing an equivalent dollar amount of RY stock (7,720 shares) with the proceeds © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 7 EXAMPLE 2. Raj reverses this trade when the target reversal price spread of $28.30 is reached on March 1, 2019 (shown in Table 21.2, Reversal section). Specifically, the trade reversal involves two simultaneous actions: a. Selling the RY position for proceeds of $798,668 (7,720 shares) b. Buying back 10,000 shares of TD for $751,600 with a portion of the proceeds 3. The net result of this initiation and reversal “round-trip trade” was a profit of $47,068. This equates to a 6.36% rate of return (RoR) and an annualized RoR of 19.08%. Table 21.2 | Equity Market-Neutral Trade Initiation (November 1, 2018) Reversal (March 1, 2019) Profit / (Loss) Security Position Market # of Total Market Market # of Total Market Profit/(Loss) Profit/ Rate of Annualized Value ($/sh) Shares Value (C$) Value ($/sh) Shares Value (C$) per Share (Loss) (C$) Return (%) Rate of Return (%/Yr) Royal Bank of Canada Long 96 7,720 740,000 103 7,720 798,669 7.60 58,669 – – Toronto Dominion Bank Short 74 10,000 740,000 75 10,000 751,600 −1.16 −11,600 – – Spread 22 – – 28 – 47,069 6.44 47,069 6.36% 19.08% CONVERTIBLE ARBITRAGE A convertible arbitrage strategy is designed to identify and exploit mispricing between convertible securities (i.e., convertible bonds or preferred shares) and the underlying stock. Convertible securities have a theoretical value that is based on a number of factors, including the value of the underlying stock. When the trading price of a convertible bond moves away from its theoretical value, an arbitrage opportunity exists. This strategy typically involves buying undervalued convertible securities and hedging some or all of the underlying equity risk by selling short an appropriate amount of the issuer’s common shares. Properly executed, this strategy creates a net position with an attractive yield that can be almost completely unaffected by broader equity market movements. Interest income on the convertible bond, added to the interest on the short sale proceeds, contributes a relatively steady return. With convertible bonds, there are further opportunities for gains, independent of market conditions, as the relative value relationship between the long bond and short stock changes. Convertible bond prices typically behave like equities when the issuer’s common shares rise well above the conversion price, the stock price at which the bond’s value can be converted into an equivalent number of common shares. Likewise, a convertible bond behaves more like a regular bond when the issuer’s common shares decline well below the conversion price. When the shares fall below the threshold, the bond trades on its investment value, that is, its value as a bond without a conversion feature. This value is based on the general level of interest rates and perceived creditworthiness of the issuer. In a declining stock market with rising interest rates, a fund that is long the convertible bond and short the common stock could realize a gain on the short stock position that exceeds the loss on the bond (which, although its value may change, cannot fall below its investment value). In a rising stock market with falling interest rates, the gain from the bond should be greater than the loss on the stock, because the amount of stock that is sold short is nearly always less than the conversion amount. © CANADIAN SECURITIES INSTITUTE 21 8 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Convertible Arbitrage Clara, an investment manager, decides to establish a trade on Tesla stock (TSLA) and a TSLA convertible bond. She believes the relative market valuation between these two securities is incorrect and that the bond is relatively cheap compared to the underlying stock. Figure 21.3 provides the share price history for the two securities over the past three years. Figure 21.3 | TSLA Market Price Comparison (Bond and Converted Bond) 3,500.0 3,000.0 2,500.0 Market Price (CAD$) 2,000.0 1,500.0 1,000.0 500.0 - 0 0 0 7 -17 7 -18 8 -18 8 -19 -19 9 -17 9 -2 r-1 t- 1 r-2 t- 1 -2 r-1 t- 1 r-1 Jan Jul Ja n Jan Jul Jul Jul Ja n Ap Oc Ap Ap Ap Oc Oc TSLA Bond TSLA Converted Equity (2.7788 Shares) Source: adapted from Bloomberg © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 9 EXAMPLE The target price spread was attained on July 7, 2017, and Clara initiated the trade by simultaneously shorting TSLA stock and going long the convertible TSLA bond. Figure 21.4 shows the market price spread between the bond and the equivalent amount of stock. Figure 21.4 | Price-Spread History and Statistics Trade Initiation 425.0 Trade Reversal 375.0 325.0 275.0 Price Spread (CAD$/share) 225.0 175.0 125.0 75.0 25.0 (25.0) (75.0) 0 0 0 7 -17 7 -18 8 -18 8 -19 -19 9 -17 9 -2 r-1 t- 1 r-2 t- 1 -2 r-1 t- 1 r-1 Jan Jul Ja n Jan Jul Jul Jul Ja n Ap Oc Ap Ap Ap Oc Oc Spread Mean 1st Std. Dev. 2nd Std. Dev. Source: adapted from Bloomberg For the sake of simplicity in this example, Clara will trade only one bond and the equivalent amount of stock that is convertible under the terms of the bond offering. This value (2.7788 shares) is determined by dividing the bond price by the conversion price, which is also set in the bond offering at $359.00; thus: ($1,000.00/C$359.87 = 2.7788 shares). The steps in the trade between the convertible TSLA bond and the underlying TSLA stock are as follows: 1. Based on her fundamental analysis, Clara decides to short the TSLA common stock and long the TSLA bonds. This trade was initiated on July 7, 2017 (shown in Table 21.3, Initiation section). Specifically, the trade initiation involved two simultaneous actions: a. Shorting 2.7788 shares of TSLA stock ($870.38, or $313.22/share equivalent) b. Purchasing a convertible TSLA bond ($1,061.10) with the proceeds © CANADIAN SECURITIES INSTITUTE 21 10 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE 2. After monitoring the trade for several months, Clara believes that the convertible TSLA bond has realized value, so she reverses the trade by selling the bond and buying back the stock. This price spread occurred on October 30, 2017 (shown in Table 21.3, Reversal section). Specifically, the trade reversal involved two simultaneous actions: a. Selling the convertible TSLA bond for proceeds of $1,094.81 b. Purchasing 2.7788 shares of TSLA stock with a portion of the proceeds ($889.44) 3. The net financial result is a profit of $14.65, which equates to a 0.99% RoR and an annualized RoR of 3.13%. Table 21.3 | Convertible Arbitrage Initiation (July 7, 2017) Reversal (October 30, 2017) Profit/(Loss) Security Position Market Value # of Total Market Market Value #r of Total Market Profit/(Loss) Profit/(Loss) Rate of Annualized ($/sh) Shares Value (C$) ($/sh) Shares Value (C$) per Share (C$) Return (%) Rate of Return (%/Yr) Convertible Bond Long 1,061 1.00 1,061 1,095 1.00 1,095 33.71 33.71 – – Convertible Bond Short 313 2.78 870 320 2.78 889 −6.86 −19.06 – – (2.77 Equivalent Shares) Spread – – 191 – – 205 – 14.65 0.99% 3.13% FIXED-INCOME ARBITRAGE A fixed-income arbitrage strategy attempts to profit from price anomalies between related interest rate securities and their derivatives, including government and non-government bonds, mortgage-backed securities, options, swaps, and forward rate agreements. Because the price anomalies are very tiny in value, high leverage is normally used to help generate returns well beyond transaction costs. Leverage for this type of fund can range from 10-to-30 times the capital employed. The two most popular fixed-income arbitrage hedge fund strategies are credit spread arbitrage and yield spread arbitrage, each of which are described below. CREDIT SPREAD ARBITRAGE Bond portfolio managers rely primarily on two skills: The ability to anticipate the future direction of interest rates (given that all bond prices are a function of interest rates) The ability to price the credit risk of the bond under consideration correctly Credit risk manifests as yield spread for the bond, which is the difference between the market yield to maturity of the risky bond and that of a sovereign government bond with a similar term to maturity. Generally, bond portfolio managers initiate bond credit spread trades in such a manner that the term to maturity of the risky bond and the sovereign bond are equal. Therefore, changes in overall market interest rates will have a negligible impact on the ultimate profitability of the credit spread trade. Accordingly, the managers attempt to add value by demonstrating their skill at determining the “proper” yield spread for the credit bond under examination. In this hedge fund strategy, the fixed-income bond manager will want to short the sovereign government bond and purchase the “cheap” credit bond when the yield spread between the two is “wide” (i.e., larger than they think it should be). If the yield spread subsequently narrows, and the manager reverses the trade, a capital gain will result. Conversely, if the yield spread widens, the trade will result in an unrealized capital loss (known as being “underwater”). © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 11 EXAMPLE Credit Spread Arbitrage James, an investment manager, has decided to establish a credit spread trade on a Royal Bank of Canada (RY) 5-year bond and a Bank of Canada (BoC) 5-year bond. Through fundamental and historical analysis of RY and its peers, James has determined that the RY’s 5-year bond is relatively cheap, and that its spread relative to the Canadian government bond is wide, given its valuation. Figure 21.5 provides the yield history for these two bonds over the past three years. Figure 21.5 | Yield to Maturity Comparison 3.50 3.00 2.50 2.00 (100 bps) 1.50 1.00 0.50 20 18 19 8 0 9 7 9 -18 7 8 -19 -17 c-1 c-1 c-1 -2 p-1 p-1 p-1 r- r- r- Jun Jun Jun Jun Ma Ma Ma De De De Se Se Se Royal Bank (5 year) Bank of Canada (5 Year) Source: adapted from Bloomberg James begins to monitor the RY bond and will initiate a trade when the credit spread widens to above 100 basis points (bps). He has determined that 100 bps is outside the bond’s relative market valuation and therefore provides an opportunity for a spread trade. James has also determined that the yield spread should tighten to, at most, 70 bps. Once the trade is initiated, James will monitor the trade and then reverse it when the bond yield has tightened to this level. The target yield spread was attained on December 7, 2018, at which point James shorted the BoC bond and used the proceeds to purchase the RY bond (for a spread of 102 bps). Six months later, on June 10, 2019, the spread fell to 70 bps. He reversed the trade by selling the RY bond and using the proceeds to purchase a BoC bond and cover the short. © CANADIAN SECURITIES INSTITUTE 21 12 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Figure 21.6 shows the yield spread on the two bonds, as well as the trade timeline. It is important to note that the trade initiation provides the yield history for these two bonds over the past three years. Figure 21.6 | Yield Spread History and Statistics Trade Initiation Trade Reversal 2.00 Yi eld Spread (100 bps) 1.50 1.00 0.50 - 20 18 19 8 8 9 9 7 7 0 -18 -19 -17 c-1 c-1 c-1 p-1 p-1 p-1 -2 r- r- r- Jun Jun Jun Jun Ma Ma Ma De De De Se Se Se Yield Spread Mean 1st Std. Dev. 2nd Std. Dev. Source: adapted from Bloomberg The bonds are priced at $1,000 at par, and James will use $1,000,000 of investor’s capital to initiate the trade. The steps in the credit spread trade between RY and BoC are as follows: 1. Based on his fundamental analysis, James decides to initiate the trade at a yield spread of 100bps or more, and to reverse it when the yield spread tightens to 70bps or less. 2. December 7, 2018, the yield spread between RY and BoC widens above 100bps, and the trade is initiated at a spread of 102bps (shown in Table 21.4, Initiation section). Specifically, the trade initiation involved two simultaneous actions: a. Shorting $1,000,000 worth of BoC bonds (1,022 bonds) b. Purchasing an equivalent dollar amount of RY bonds (1,033 bonds) with the proceeds © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 13 EXAMPLE 3. James reverses this trade as soon as the target reversal price spread of at least 70bps is reached. This yield spread occurs on June 10, 2019 (shown in Table 21.4, Reversal section). Specifically, the trade reversal involved two simultaneous actions: a. Selling the RY position for proceeds of $1,042,297 (1,033 bonds) b. Purchasing 1,022 bonds of BoC with a portion of the proceeds ($1,025,066) 4. The net result of this round-trip trade is a profit of $17,231. This equates to a 1.72% RoR on the initial $1,000,000 investment, which corresponds to an annualized RoR of 3.45%. Table 21.4 | Credit Arbitrage Initiation (December 7, 2018) Reversal (June 10, 2019) Profit/(Loss) Security Position YTM Market # of Total Market YTM Market # of Total Market Profit/ Profit/ Rate of Annualized (%/Yr) Value of Bonds Value (C$) (%/Yr) Value of Bonds Value (C$) (Loss) per (Loss) Return Rate of Bond Bond Bond $ (C$ 000’s) (%) Return (C$ 000’s) (C$ 000’s) (%/Yr) Royal Bank of Long 3.02 968 1,033 1,000,000 2.12 1,009 1,033 1,042,297 41 42,297 – – Canada – 5 Year Government of Short 2.00 979 1,022 1,000,000 1.42 1,003 1,022 1,025,066 −24 −25,066 – – Canada – 5 Year Spread 1.02 −10 – – 0.70 6 – 17,231 16 17,231 1.72% 3.45% YIELD SPREAD ARBITRAGE In a yield spread arbitrage strategy, the manager is only concerned with the yield curve of a single issuer. Due to the liquidity and vast choice of bonds, the yield spread arbitrage strategy is normally only implemented with a sovereign yield curve (BoC or the U.S. treasury). Managers of yield spread strategies attempt to add value by demonstrating their skill at forecasting the shape of the yield curve at a future moment. The manager implements the strategy to realize a targeted RoR based on the expected yield curve. For example, if the manager believes that the yield curve will flatten (when the difference between the yield on the longer-dated security and the shorter-dated security becomes smaller), they will sell the shorter-dated security and purchase the longer-dated security. It is important to note that managers of this strategy can and do use any combination of terms found on the yield curve. © CANADIAN SECURITIES INSTITUTE 21 14 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Yield Spread Arbitrage Lydia has been monitoring the U.S. treasury bond market and believes that the U.S. treasury yield curve is going to flatten. She believes that the difference between the yield on the longer-dated security and the shorter-dated security will grow smaller as a result. She decides to establish a yield spread trade between the U.S. Treasury 3-year and 10-year bonds. Figure 21.7 provides the yield history for the two bonds over the past three years. Figure 21.7 | Yield Comparison 3.5 3.0 2.5 2.0 (100 bps) 1.5 1.0 0.5 0 -0.5 20 18 19 8 9 7 8 7 9 -18 -19 -17 c-1 c-1 c-1 p-1 p-1 p-1 r- r- r- Jun Jun Jun Ma Ma Ma De De De Se Se Se U.S. Treasury (10 Year) U.S. Treasury (3 Year) Source: adapted from Bloomberg © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 15 EXAMPLE Figure 21.8 shows the yield spread on the two bonds, as well as the trade timeline. It is important to note that the trade initiation provides the yield spread history for these two bonds over the past three years. Figure 21.8 | Yield Spread History and Statistics Trade Initiation Trade Reversal 1.25 0.75 Yi eld Spread (100 bps) 0.25 -0.25 -0.75- 20 18 19 8 9 7 8 7 9 -18 -19 -17 c-1 c-1 c-1 p-1 p-1 p-1 r- r- r- Jun Jun Jun Ma Ma Ma De De De Se Se Se Share Price Spread Mean 1st Std. Dev. 2nd Std. Dev. Source: adapted from Bloomberg The bonds are US$1,000 at par each, and Lydia uses US$1,000,000 of investor’s capital to initiate the trade. After analyzing the U.S. treasury yield curve, Lydia is confident that the yield curve will flatten sometime over the next year. The steps in the trade are as follows: 1. Lydia initiates the trade on September 18, 2018 at a spread of 27 bps between the two U.S. treasury bonds (shown in Table 21.5, Initiation section) Specifically, the trade initiation involved two simultaneous actions: a. Shorting US$1,000,000 worth of U.S. Treasury 3-year bonds (1,022 bonds) b. Purchasing an equivalent dollar amount of U.S. Treasury 10-year bonds (1,053 bonds) with the proceeds of the short sale © CANADIAN SECURITIES INSTITUTE 21 16 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE 2. Over the next two quarters, Lydia continuously monitors the yield curve and decides to reverse the trade when the spread between the two bonds falls to 5 bps on March 22, 2019 (shown in Table 21.5, Reversal section). Table 21.5 provides the price calculations and dollar amounts associated with the initiation at 27 bps and the trade reversal at 5 bps. Specifically, the trade reversal involves two simultaneous actions: a. Selling the U.S. treasury 10-year bond position for proceeds of US$1,051,947 (1,053 bonds) b. Purchasing 1,022 U.S. Treasury bonds (US$1,010,984) with a portion of the proceeds to cover the short position 3. The net financial result of this round-trip trade is a profit of US$40,963, which equates to a 4.10% RoR on the initial US$1,000,000 investment and corresponds to an annualized RoR of 8.08%. Table 21.5 | Yield Arbitrage Initiation (September 18, 2018) Reversal (March 22, 2019) Profit/(Loss) Security Position YTM Market # of Total Market YTM Market # of Total Market Profit/ Profit/ Rate of Annualized (%/Yr) Value of Bonds Value (C$) (%/Yr) Value of Bonds Value (C$) (Loss) per (Loss) Return Rate of Bond Bond Bond ($) (C$ 000’s) (%) Return (C$ 000’s) (C$ 000’s) (%/Yr) U.S. Treasury – Long 3.06 950 1,053 1,000,000 2.44 999 1,053 1,051,947 49 51,947 – – 10 Year U.S. Treasury – Short 2.79 979 1,022 1,000,000 2.39 989 1,022 1,010,984 −11 −10,984 – – 3 Year Spread 0.27 −29 – – 0.05 10 – 40,963 39 40,963 4.10% 8.08% EVENT-DRIVEN STRATEGIES As mentioned, event-driven strategies seek to profit from unique corporate structure events. They include merger strategies (also called risk arbitrage strategies), high-yield bond strategies, and distressed securities strategies. MERGER (RISK ARBITRAGE) STRATEGY A merger strategy (or risk arbitrage strategy) invests simultaneously in long and short positions in the common stock of companies involved in a proposed merger or acquisition. The strategy usually involves taking a long position in the company being acquired and a short position in the acquiring company. The alternative strategy fund manager attempts to take advantage of the differential between the target company’s share price and the offering price. Typically, the share price of the target company rises after a takeover or merger announcement but does not rise to the full offering price because of the risk that the deal may not close. The returns on merger arbitrage are largely uncorrelated to the overall stock market. In general, equity risk is managed (controlled) because the alternative strategy fund manager deals with the probable outcomes of specific transactions rather than with predicting the overall market. © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 17 EXAMPLE ABC makes an offer to acquire XYZ for $50 per share, a 25% premium to its current price, payable in stock. ABC’s stock fell a couple percent on the news, to $10 per share, because the acquisition would be slightly dilutive to its earnings per share this year and only modestly accretive to next year’s earnings. Risk arbitrageurs shorted five shares of ABC for each one share they acquired of XYZ (Hedge ratio = XYZ $50 share price / ABC $10 share price = 5). Because the deal is subject to regulatory review and shareholder approval, XYZ is trading at only $48 per share which is a 4% discount to the hedged $50 transaction value. Assuming six months to completion, this represents an annualized return of over 8% that a risk arbitrage fund would typically seek to improve by using leverage. DID YOU KNOW? If the acquiring firm’s earnings per share decreases post-merger due to a lower earnings contribution from the targeted firm, the deal is considered to be dilutive. If the acquiring firm’s earnings per share increases post-merger due to the strong earnings contribution of the targeted firm, the deal is considered to be accretive. Mergers are often dilutive for the acquiring firm until positive synergies that result from the merger take effect. HIGH-YIELD BONDS A high-yield bond strategy is a type of credit strategy that invests in below-investment-grade debt securities, otherwise known junk bonds. These bonds are typically rated BB or lower by Standard & Poor’s and Ba or lower by Moody’s. Managers of this strategy look to earn returns through interest income and capital appreciation (by way of credit upgrade or takeover). High-yield credit securities can offer higher long-term returns than that of traditional investment grade credit securities through both the generation of interest income and potential capital appreciation. However, they have a greater risk profile. Compared to investment grade credit securities, high-yield securities have historically higher levels of default, which managers must consider when analyzing potential investments and through continual monitoring once held in the portfolio. DISTRESSED SECURITIES A distressed securities strategy invests in the equity or debt securities of companies that are in financial difficulty and facing bankruptcy or reorganization. Distressed securities generally sell at deep discounts, reflecting their issuers’ weak credit quality. Managers of this strategy analyze companies on the verge of insolvency and then take a position in one company’s bonds in hope that the restructuring or liquidation of the company will lead to a return greater than the cost of the bonds. Restructuring can happen in either of two ways: Voluntary restructuring, where bondholders and management come to new terms that allow the company to continue operating Involuntary restructuring, where the bond issuer enters bankruptcy, and the restructuring or payout of company assets is decided by the court system This strategy is commonly considered a subset of a high-yield bond strategy; however, the bonds held in a high- yield portfolio tend to be in relatively good standing, whereas the bonds held in a distressed debt portfolio are currently in or near bankruptcy (and may have already suspended coupon payments). © CANADIAN SECURITIES INSTITUTE 21 18 CANADIAN SECURITIES COURSE      VOLUME 2 Many institutional investors are not permitted to own securities that are rated less than investment grade. Therefore, downgrading the credit rating of an issuer or security to below the permissible minimum can precipitate a wave of forced selling that depresses the security’s value below fair market value. Alternative strategy fund managers attempt to profit from the market’s lack of understanding of the true value of deeply discounted securities or the inability of institutional and other investors to hold these securities. DIRECTIONAL STRATEGIES As mentioned, directional strategies involve high exposure to market direction. They include long/short equity strategies, global macro strategies, emerging market strategies, dedicated short bias strategies, and managed futures strategies. LONG/SHORT EQUITY The long/short equity strategy is a popular type of alternative fund strategy in Canada. These funds are classified as directional funds because the manager has either a net long or net short exposure to the stock market. The manager is not trying to eliminate market effects or market trends completely, as would be the case with an equity market-neutral strategy; rather, he or she takes both long and short positions simultaneously, depending on the outlook of specific securities. With a long/short equity strategy, managers try to buy stocks they feel will rise more in a bull market than the overall market and sell short stocks that will rise less. In a down market, good short selections are expected to decline more than the market and good long selections will fall less. In a long/short equity strategy, the fund is exposed to market risk based on the extent of the net exposure - either long or short. Compared to a long-only fund, this type of fund is often better able to profit in a declining market, as it can short stocks and manage the fund’s net exposure to the market. The amount of leverage used is usually modest and rarely more than three or four times the capital employed. Most of these types of funds use smaller amounts. A long/short equity fund’s net exposure is calculated as follows: Long Exposure − Short Exposure Net exposure (in percentage terms) = Capital It is probably most appropriate to explain the equity long/short investment strategy in relation to the equity market-neutral strategy. First, the equity market-neutral strategy consists of a portfolio of pairs, where the individual stocks have identical market values. This results in a portfolio having theoretically zero beta, with no exposure to overall market movements. Secondly, the primary difference is that the equity long/short strategy has, by definition, net exposure to the overall market, meaning that portfolio beta is not equal to zero. In terms of implementation, an equity long/short manager will adopt one of two investment strategies, as follows: 1. The first strategy combines an equity market-neutral portfolio (similar to the one discussed earlier) with a long or short position in suitable equity index futures. (Note that the equity market-neutral component is referred to as “in-the-trade”, and the futures position is “out-of-the-trade”.) 2. With the second strategy, the portfolio manager creates a portfolio of pair trades, wherein the long position does not equal the market value of the short position. In this way, the manager has added net market exposure to the portfolio without using derivatives. In the example below, the long/short equity strategy is of the first type, having a balanced long and short trade coupled with the exposure of a long position in a S&P/TSX 60 futures contract. © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 19 DID YOU KNOW? The S&P/TSX 60 futures contract can be used by investors to trade and hedge exposure (long or short) on the Canadian equity market. The market value of a S&P/TSX 60 futures contract is calculated by taking the current value of the S&P/TSX 60 Index and multiplying it by $200. Index Value × $200 = Market Value of Futures Contract (C$) For example, if the index had a value of 850.00 on a given day, then the market value would equal $170,000. EXAMPLE Long/Short Equity Strategy In this example, the underlying equal-dollar long/short position is the same strategy as the one used in the equity market-neutral example. The only difference is the addition of a futures contract to the long position. The process is also identical to the one used to create a pairs trade in the equity market-neutral example, with the addition of extra steps. Steps 2 (c) and 3 (c) are added for the inclusion of the net long Canadian equity futures investment position. Just as in the equity market-neutral example, the investment manager initiates the trade with $740,000 of investor’s capital. The initiation and eventual reversal of the trade are as follows: 1. Using fundamental analysis, Victor, the investment manager, decides to initiate a pairs trade at a price spread of $22.00 or less, and to reverse the trade when the price spread is at least $28.00. 2. Subsequently, on November 1, 2018, the price spread between RY and TD was at or below the target price spread of C$22.00. Accordingly, the trade was initiated at a price spread of C$21.86 (shown in Table 21.6, Initiation section). Specifically, the trade initiation involves three simultaneous actions: a. Shorting $740,000 worth of TD stock (10,000 shares) b. Purchasing an equivalent dollar amount of RY stock (7,720 shares) with the proceeds c. Establishing a long position in one S&P/TSX 60 futures contract at a value of 900.70 ($180,140.00) 3. Victor reverses this trade by selling RY and buying back TD as soon as the target reversal price spread of at least $28.00 has been reached. This price spread occurred on March 1, 2019 at a price spread of $28.30 (shown in Table 21.6, Reversal section). Specifically, the trade reversal involves three simultaneous actions: a. Selling the RY position for proceeds of $798,668 (7,720 shares) b. Purchasing 10,000 shares of TD ($751,600) with a portion of the proceeds c. Selling the S&P/TSX 60 futures contract at a value of 958.23 ($191,646) (Note that, between November 1, 2018 and March 1, 2019, the S&P/TSX 60 index moved from 900.70 to 958.23, which is equivalent to a RoR of 6.39%.) 4. The net financial result of this round-trip trade is a profit of C$58,575, which equates to a 7.92% RoR on the initial C$740,000 investment. This return corresponds to an annualized RoR of 23.75%. © CANADIAN SECURITIES INSTITUTE 21 20 CANADIAN SECURITIES COURSE      VOLUME 2 EXAMPLE Table 21.6 | Long/Short Equity Strategy Initiation (November 1, 2018) Reversal (March 1, 2019) Profit/(Loss) Security Position Market # of Shares/ Total Market Market # of Shares/ Total Market Profit/ Profit/(Loss) Rate of Annualized Value (C$/ Index Value Value (C$) Value (C$/ Index Value Value (C$) (Loss) (C$/ (C$) Return Rate of share/Index Share/Index Share/ (%) Return Value) Value) Contract) (%/Yr) Royal Bank of Canada Long 96 7,720 740,000 103 7,720 798,670 7.60 58,669.82 – – Toronto Dominion Bank Short 74 10,000 740,000 75 10,000 751,600 −1.16 −11,600.00 – – S&P TSX 60 Futures Long 901 1 180,140 958 1 191,646 11,506.00 11,506.00 – – Total 58,575.82 7.92% 23.75% GLOBAL MACRO Rather than betting on events that affect only specific companies, funds using a global macro strategy make bets on major events affecting entire economies. For example, they might base their strategy on shifts in government policy that alter interest rates, thereby affecting currency, stock, and bond markets. Global macro funds participate in all major markets, including equities, bonds, currencies, and commodities. They use leverage, often through derivatives, to accentuate the impact of market moves. Global macro managers monitor the following factors, among others, to find and exploit inefficiencies and dislocations in domestic and foreign markets: Trade statistics (import/export) Corporate earnings Exchange rate dislocations Domestic and foreign policy developments Investor bias on global economy Non-economic investing activities, such as: Corporate or sovereign debt downgrades Political events Central bank intervention in the domestic or foreign exchange market DID YOU KNOW? Exchange rate dislocation refers to exchange rates deviating from historical relationships as a result of mispricing that arises in unusual or stressful market circumstances. Global macro managers typically use either of two different styles of analysis when searching for opportunities in the market: discretionary and systematic. Most managers employ aspects of both types of analyses in their investment decision-making process; however, the styles differ greatly, and managers are typically classified as one or the other type. The management styles are as follows: © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 21 Discretionary managers Discretionary managers construct portfolios using a top-down analysis approach, analyzing the world economy. Their goal is to predict the direction of underlying markets and asset classes. Systematic managers Systematic managers construct portfolios using a bottom-up analysis approach, employing the use of models and algorithms on large sets of economic data. Their goal is to predict the movement of financial market prices. EXAMPLE If the United States were to place tariffs on Japanese exports, it could have resonating effects throughout Japan’s manufacturing sectors and greater economy. A global macro manager who believes that such tariffs will be imposed might take short positions in certain securities, such as Japanese manufacturing indices, specific stocks, and the Japanese yen. If the manager is correct, and the tariffs are enacted, the manager stands to earn a return from his positions. The manager could also hedge these positions by taking long positions in the U.S. manufacturing sectors and companies that he believes stand to gain from the potential imposition of tariffs. EMERGING MARKETS Emerging markets alternative funds invest in equity and debt securities of companies in emerging markets. Such a fund is not a strategy in itself; rather, the term refers to any number of hedge funds that invest in the securities of emerging market nations. The primary difference between an emerging markets alternative strategy fund and an emerging markets mutual fund is the alternative strategy fund’s greater ability to use derivatives, short selling, and other complex investment strategies. Managers rank emerging market countries differently depending on the factors they consider to be the most important drivers of performance, as well as the type of securities they intend to invest in. These factors include, but are not limited to: Gross domestic product growth rate Political stability Level of financial market regulation Social stability (based on average level of education and health statistics) Environmental stability (based on whether a sector or economy is affected by seasonal weather, such as flooding, drought, or earthquakes) Considering the factors above, many countries can be categorized as an emerging market opportunity, each with its unique risk-reward profile. For example, some emerging market funds concentrate specifically on regions with similar securities, such as commodity development in South America or Africa, or manufacturing in South Asia. Managers can also look for broad-growth opportunities from a range of countries with diverse economies. One such fund type, known as BRIC funds, invest in a range of securities in the emerging markets of Brazil, Russia, India, and China (BRIC). The opportunity for greater reward also entails greater risk. No matter the security type, emerging market managers face the same underlying risks that managers of securities from developed nations face, coupled with a several additional risks. © CANADIAN SECURITIES INSTITUTE 21 22 CANADIAN SECURITIES COURSE      VOLUME 2 Other risks to consider are as follows: Political risk, which can lead to extreme volatility in all security markets (equity, debt, currency and real estate) Currency risk Inflation risk Under-developed capital markets, which can entail the following risks: Liquidity risk (risk of thinly traded securities) Wide bid/ask spreads leading to high transaction costs Hedging risk, where laws prohibit short selling Transparency risk, where under-developed regulatory systems result in lower-quality financial reporting standards (or lack of same) Furthermore, because of debt held by foreign investors, and because under-developed capital markets and regulatory systems can limit short positions, many strategies used in emerging markets are long-only. DEDICATED SHORT BIAS To be classified as short bias, the fund’s net position must always be short. In other words, the fund may have long positions, but on a net basis, the fund must constantly be short. It is important to distinguish between a dedicated short bias strategy and a dedicated short strategy. A dedicated short strategy takes short positions in the portfolio (naked shorts) exclusively. A dedicated short bias strategy can have any number of long positions in the portfolio, but the net exposure must be short. In either case, many managers consider these strategies to be a subset of a long/short strategy. The advantage of having short and long positions, rather than having only naked shorts, is that the long positions can help keep losses on the shorts manageable during extended bull markets. The disadvantage to this strategy is that, when the market flips into a bear market, the potential losses on the long positions in the portfolio will limit the gains on the short positions. The main skill involved in managing portfolios with a net short exposure is the ability to correctly identify overpriced securities using fundamental and technical analysis. The major risk involved in these strategies is the cost of maintaining the margin balances. Managers must have enough cash to continually cover margin calls in case the market moves opposite to their position. If they run out of available funds, then the position will most likely have to be closed at a loss. This risk can be further exacerbated if leverage has been applied to either the short or long positions, and the market moves for an extended period in one direction. MANAGED FUTURES A managed futures strategy commonly refers to a portfolio of futures contracts that is actively managed by professionals. Futures can be used by investment managers in a number of hedge fund strategies, including equity market-neutral, long/short, and short biased to name a few. However, some managers, known as commodity trading advisors (CTAs), manage futures exclusively and provide advice on futures investing. The CTA is responsible for advising on managed accounts and pooled investment vehicles such as commodity pools. Specifically, they advise investors about the value of commodity futures or options. The organizations that manage commodity pools are known as commodity pool operators (CPOs). Both CTAs and CPOs are regulated separately from traditional investment managers by the Commodity Futures and Trading Commission and the National Futures Association. These entities oversee reporting requirements and conduct audits on the pools. © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 23 Most managed futures managers follow a strategy called trend-following, otherwise known as a momentum strategy. In contrast to traditional investing strategies that focus on value or growth, managers of trend-following strategies seek out securities that have moved in one direction for an extended period. Two trend-following strategies that managers can employ are as follows: Time-series momentum This strategy uses fundamental analysis and historical prices (i.e., technical analysis) strategy to identify market trend signals. The strategy assumes that assets with a positive trend will continue to have a future positive trend, and that assets with a negative trend will have a future negative trend. Once the analysis is complete, the manager will go long the positive-trend assets and short the negative-trend assets. Cross-sectional This strategy takes positions in pairs of securities based on relative signals. The momentum strategy manager will take a long position in the security with relatively positive momentum, and short the security with relatively negative momentum. This strategy is usually executed on single stocks, and the long and short positions are equal (so that general market movements have no effect on the pair traded.) Managed futures are one of the earliest types of hedge fund strategies practised. The universe of futures that managers can invest in is not limited to commodities, as their title would suggest, but includes all types of futures. The four major futures categories are as follows: Commodities, such as gold, crude oil, coffee, orange juice, and soybean futures Currencies, such as US dollar, yen, and euro futures Stock Index, such as Dow, S&P, and NASDAQ index futures, and Fixed Income, such as US Treasury bond and foreign sovereign bond futures Managed futures have the following advantages: High liquidity Low friction costs (futures trade with ‘tight’ bid/ask spreads) Complete price transparency Facilitates “direct” access to underlying risk (e.g., gaining exposure to gold bullion prices through a futures contract, rather than equity or fixed-income investing in a gold mining company) DID YOU KNOW? Systematic futures managers take positions across a large number of markets that tend to be uncorrelated with each other. MANAGED FUTURES SUBSET – CURRENCY Currency managed futures can sometimes be classified under global macro. Managers invest in single or multiple currencies through the use of short-term money market instruments combined with derivative instruments such as futures, forward currencies, swaps, and options. A manager may see an opportunity to profit from a perceived misevaluation of one currency relative to another. Some managers consider currency to be its own asset class, and several academic papers have suggested that the inclusion of currency in a traditional 60/40 portfolio can increase the expected return for a given level of risk on the efficient frontier. © CANADIAN SECURITIES INSTITUTE 21 24 CANADIAN SECURITIES COURSE      VOLUME 2 MULTI-STRATEGY FUNDS In a multi-strategy fund, a single fund manager invests in multiple fund strategies within a single fund vehicle. For example, for one fund, a manager may mix relative value, event-driven and directional strategies. Through this type of fund, an investor’s exposure to different strategies may change slightly over time in response to market movements or the manager’s discretion. The diversification provided by inclusion of this range of strategies can provide the following benefits: Reduced volatility Potential for enhanced risk-adjusted returns Reduced concentration risk, through: Decreased security-specific risks Decreased strategy-specific risks In regard to the risks associated with multi-strategy funds, there are several integrated layers. First, each underlying strategy is exposed to specific risks. Second, the more strategies that are brought on by the manager, the less time the manager will have to monitor the securities held in each strategy and market movements at large. It is important to note the differences between a multi-strategy hedge fund and a fund of funds (FOF). As mentioned previously, the multi-strategy manager is a single manager who operates several different hedge fund strategies, whereas a FOF manager invests capital across a range of strategies managed by different managers. Fund-of-funds investing has an increased diversification benefit because the manager can invest with more managers and strategies than a single manager would be able to. Moreover, FOF investing further reduces concentration and operational risk. The main criticism of FOF investing is that, by using a multi-tier level of managers, the added management fees erode returns. LEVERAGED ETF STRATEGY A leveraged exchange-traded fund (ETF) is designed to achieve returns that are multiples of the performance of the underlying index it tracks. The use of leverage, or borrowed capital, makes the fund more sensitive to market movements. The fund uses borrowed capital in addition to investor capital to provide a higher level of exposure to the underlying index. Typically, a leveraged ETF uses $2 of leverage for every $1 of investor capital (commonly referred to as two times or double). The goal is to generate a return made with the borrowed capital that exceeds what it cost to acquire the capital itself. A leveraged ETF will multiply the reference asset’s returns by more or less than the stated leverage factor, over periods longer than their rebalancing frequency. Whether more or less depends on the path of the returns over the longer time horizon. For example, an ETF designed to give double the daily return of a reference asset will not provide double the return of the reference asset over a month’s time. If the reference asset steadily increased over the month, the leveraged ETF return would be more than double. If the reference asset increased by the same amount during a month, but did so over a highly volatile path, the leveraged ETF return would be considerably less than double. The reason for this lies in the portfolio management strategy of a daily leveraged ETF. In the example of an ETF designed to give double the daily return of a reference asset, the leveraged ETF gains net asset value when the reference asset gains value. A 3% rise on an index value of 100 results in a value of 103. The ETF assets, with $100 of borrowed money, rise from $200 to $206. The leverage factor is now less than 2 (calculated as total assets/account equity = $206/$106 = 1.94). To restore the double leverage, the ETF must add to its leveraged position and borrow more to increase net assets from $206 to $212 (calculated as $212/$106 = 2). By adding to the leveraged position, the ETF is averaging up. © CANADIAN SECURITIES INSTITUTE  CHAPTER 21      ALTERNATIVE INVESTMENTS: STRATEGIES AND PERFORMANCE 21 25 Typical portfolio management strategy calls for averaging down, buying more positions in the security as it falls in price. New derivatives positions added at a higher cost increase exposure to one side of the market. This strategy works well when the price of the reference asset keeps going up. But with a higher dollar exposure to one side, the ETF is vulnerable to more losses than it would be if it did nothing and the reference asset fell. Compounded repeatedly, the leveraged ETF in a volatile market will deviate from double the holding period return. Investors in leveraged ETFs will not only need to predict the return of the reference asset but will also have to predict the path of the return. INVESTMENT STRATEGIES MOST APPROPRIATE FOR ALTERNATIVE MUTUAL FUNDS Alternative mutual funds need to be compliant with regulatory limits with respect to the use of derivatives, leverage, short selling, and illiquid securities. These limitations prevent or discourage liquid alternative funds from utilizing some of the strategies that are available to hedge funds who have no such regulatory limitations. The requirement for an alternative mutual fund to calculate a daily net asset value (NAV) and offer daily liquidity for investor redemptions favours the use of certain alternative investment strategies. The following bullet points provide an approximate ranking of alternative investment strategies on the combined basis of fund liquidity and ability to calculate accurate NAVs. These investment strategies are listed from most liquid to least liquid: Managed futures/commodities Equity market-neutral and long/short equity Global macro Dedicated short bias Merger or risk arbitrage Fixed-income arbitrage Convertible arbitrage High-yield bonds and distressed securities Emerging markets Private equity and equity real estate The alternative investment strategies primarily investing in futures or large capitalization equities will provide the highest degree of fund liquidity. These would be the strategies listed in the first six bullet points above (from managed futures/commodities to fixed-income arbitrage). The second most liquid investment strategies would be the strategies for the next two bullets points (convertible arbitrage, high-yield bonds and distressed securities). These fixed-income-related alternative investment strategies involve investment in corporate bonds, including issuers that have very low credit ratings. They are used by only a relatively small number of fixed-income investors. They typically offer less fund liquidity than the first category. The third most liquid alternative investment strategy invests in emerging markets. This alternative investment strategy invests in equities listed on foreign stock exchanges. Liquidity in emerging markets is generally much lower than North American markets. Finally, private equity and equity real estate are the most illiquid of all alternative investment strategies listed. Most alternative mutual funds utilize the strategies listed in the first six bullet points above. There is a much smaller use of the second and third most liquid alternative investment strategies. Finally, very few alternative mutual funds © CANADIAN SECURITIES INSTITUTE 21 26 CANADIAN SECURITIES COURSE      VOLUME 2 utilize private equity or equity real estate investment strategies due to their inability to provide accurate fund NAVs and support investor redemption requests. ALTERNATIVE STRATEGY CATEGORIES Can you identify the category that each alternative strategy belongs to? Complete the online learning activity to assess your knowledge. ALTERNATIVE STRATEGY FUND PERFORMANCE MEASUREMENT 3 | Discuss risk measures and risk-adjusted return measures to alternative strategy fund investments. 4 | Discuss benchmarking of alternative investment performance. There are several risk and risk-adjusted measures that are important for investors interested in alternative strategies to understand when selecting an investment. While earlier chapters introduced the concept of standard deviation and the Sharpe ratio, and they are touched on briefly below, this section also introduces you to the important concepts of return distributions, downside risk and maximum drawdowns. RISK MEASURES ABSOLUTE RISK Absolute risk is defined as the total variability or volatility of returns. Total variability incorporates all sources of risk embedded in returns, including first- and second-order risks, and does not distinguish between upside and downside volatility. STANDARD DEVIATION One measure of risk that has gained widespread acceptance within the securities industry is the standard deviation of returns. The standard deviation of returns, which is derived from the variance of returns, measures the extent to which returns differ from some average or expected level of return. The more individual returns differ from the average or expected return, the bigger the variance and standard deviation and, hence, the greater the risk. If the standard deviation is calculated using, say, monthly returns, then the standard deviation is a monthly standard deviation, that is, the average deviation of monthly returns from the average monthly return. For example, the monthly standard deviation of the ABC fund based on three years of monthly returns was 3.93%. If the standard deviation is calculated using anything other than annual returns, it is often annualized so that it can be compared to the standard deviation of other investments, which may or may not have been calculated using similar time periods. To calculate the annual standard deviation f