Alternative Investments – An Allocator′s Approach – Fourth Edition

Preface xxxix Acknowlegements xli About the Authors xlv Part 1 Ethics Regulations and ESG Chapter 1 Asset Manager Code 3 1.1 General Principles of Conduct 3 1.2 Asset Manager Code 3 1.3 Notification of Compliance 5 1.4 Additional Guidance for the Asset Manager Code 6 Chapter 2 Recommendations and Guidance 11 Chapter 3 Global Regulation 27 3.1 Overview of Financial Market Regulation 27 3.2 Regulation of Alternative Investments Within the United States 28 3.3 Alternative Investment Regulation in Europe 38 3.4 Hedge Fund Regulation in Asia 45 Chapter 4 ESG and Alternative Investments 49 4.1 Background on ESG and Alternative Investing 49 4.2 ESG and Real Assets: Natural Resources 51 4.3 ESG and Real Assets: Commodities 53 4.4 ESG and Real Assets: Real Estate 55 4.5 ESG and Hedge Funds 61 4.6 ESG and Private Equity 66 Chapter 5 ESG Analysis and Application 71 5.1 Background on ESG 71 5.2 ESG Ratings and Scores 73 5.3 ESG Materiality and Disclosure 74 5.4 The United Nations Role in ESG Issues 76 5.5 ESG Fiduciary Responsibilities and Regulation 78 5.6 Methods of ESG Investing 80 5.7 Market-Based Methods of Addressing ESG Issues 85 5.8 ESG and Special Investment Consideration 87 Part 2 Models Chapter 6 Modeling Overview and Interest Rate Models 93 6.1 Types of Models Underlying Investment Strategies 93 6.2 Equilibrium Fixed-Income Models 96 6.3 Arbitrage-Free Models of the Term Structure 99 6.4 The Black-Derman-Toy Model 100 6.5 P-Measures and Q-Measures 103 Chapter 7 Credit Risk Models 105 7.1 The Economics of Credit Risk 105 7.2 Overview of Credit Risk Modeling 109 7.3 The Merton Model 110 7.4 Other Structural Models: KMV 117 7.5 Reduced-Form Models 120 7.6 Empirical Credit Models 123 Chapter 8 Multi-Factor Equity Pricing Models 127 8.1 Multi-Factor Asset Pricing Models 127 8.2 FAMA-French Models 131 8.3 Three Challenges of Empirical Multi-Factor Models 133 8.4 Factor Investing 135 8.5 The Adaptive Markets Hypothesis 141 8.6 Time-Varying Volatility 142 8.7 Stochastic Discount Factors 143 8.8 Summary of Multiple-Factor Asset Allocation 145 Chapter 9 Asset Allocation Processes and the Mean-Variance Model 147 9.1 Asset Allocation Processes and the Mean-Variance Model 147 9.2 Implementation of Mean-Variance Optimization 155 9.3 Mean-Variance Optimization with Multiple Risky Assets 160 9.4 Mean-Variance Optimization and Hurdle Rates 162 9.5 Issues in Using Optimization for Portfolio Selection 163 9.6 Adjustment of the Mean-Variance Approach for Illiquidity 166 9.7 Adjustment of the Mean-Variance Approach for Factor Exposure 168 9.8 Mitigating Estimation Error Risk in Mean-Variance Optimization 168 Chapter 10 Other Asset Allocation Approaches 175 10.1 The Core-Satellite Approach 175 10.2 Top-Down and Bottom-Up Asset Allocation Approaches 176 10.3 Risk Budgeting 178 10.4 A Factor-Based Example of Implementing A Risk Budgeting Approach 181 10.5 Risk Parity 183 10.6 Other Quantitative Portfolio Allocation Strategies 189 10.7 The New Investment Model 193 Part 3 Institutional Asset Owners and Investment Policies Chapter 11 Types of Asset Owners and the Investment Policy Statement 197 11.1 Endowments and Foundations 197 11.2 Pension Funds 198 11.3 Sovereign Wealth Funds 199 11.4 Family Offices 199 11.5 Strategic Asset Allocation: Risk and Return 199 11.6 Asset Allocation Objectives 202 11.7 Investment Policy Constraints 202 11.8 Investment Policy Statements for Institutional Asset Owners 204 Chapter 12 Foundations and the Endowment Model 221 12.1 Defining Endowments and Foundations 221 12.2 Intergenerational Equity, Inflation, and Spending Challenges 224 12.3 The Endowment Model 226 12.4 Why Might Large Endowments Outperform? 228 12.5 Risks of the Endowment Model 234 12.6 Liquidity Rebalancing and Tactical Asset Allocation 239 12.7 Tail Risk 240 12.8 Conclusion 242 Chapter 13 Pension Fund Portfolio Management 245 13.1 Development, Motivations, and Types of Pension Plans 245 13.2 Risk Tolerance and Asset Allocation 247 13.3 Defined Benefit Plans 251 13.4 Governmental Social Security Plans 258 13.5 Contrasting Defined Benefit and Contribution Plans 259 13.6 Annuities for Retirement Income 262 13.7 Conclusion 266 Chapter 14 Sovereign Wealth Funds 269 14.1 Sources of Sovereign Wealth 269 14.2 Four Types of Sovereign Wealth Funds 272 14.3 Establishment and Management of Sovereign Wealth Funds 274 14.4 Governance and Political Risks of SWFs 277 14.5 Analysis of Three Sovereign Wealth Funds 279 14.6 Conclusion 282 Chapter 15 Family Offices and the Family Office Model 285 15.1 Identifying Family Offices 285 15.2 Goals, Benefits, and Business Models of Family Offices 286 15.3 Family Office Goals by Generations 290 15.4 Macroeconomic Exposures of Family Offices 295 15.5 Income Taxes of Family Offices 297 15.6 Lifestyle Assets of Family Offices 300 15.7 Family Office Governance 304 15.8 Charity, Philanthropy, and Impact Investing 307 15.9 Ten Competitive Advantages of Family Offices 310 Part 4 Risk and Risk Management Chapter 16 Cases in Tail Risk 315 16.1 Problems Driven by Market Losses 315 16.2 Trading Technology and Financial Crises 324 16.3 Failures Driven by Fraud 326 16.4 Four Major lessons From cases in Tail Events 334 Chapter 17 Benchmarking and Performance Attribution 337 17.1 Benchmarking and Performance Attribution Overview 337 17.2 Single-Factor Benchmarking and Performance Attribution 340 17.3 Multi-Factor Benchmarking 344 17.4 Distinctions Regarding Alternative Asset Benchmarking 346 17.5 Benchmarking of Commodities 348 17.6 Three Approaches to Benchmarking Managed Futures Funds 351 17.7 Benchmarking Private Equity Funds 352 17.8 Group Peer Returns as Benchmarks 357 17.9 Benchmarking Real Estate 358 Chapter 18 Liquidity and Funding Risks 363 18.1 Margin Accounts and Collateral Management 363 18.2 Value at Risk for Managed Futures 367 18.3 Other Methods of Estimating Liquidity Needs 369 18.4 Smoothed Returns on Illiquid Funds 373 18.5 Modeling Price and Return Smoothing 375 18.6 Unsmoothing a Hypothetical Return Series 378 18.7 Unsmoothing Actual Real Estate Return Data 380 Chapter 19 Hedging, Rebalancing, and Monitoring 389 19.1 Managing Alpha and Systematic Risk 389 19.2 Managing the Risk of a Portfolio with Options 391 19.3 Delta-Hedging of Option Positions 394 19.4 Three Key Observations on Delta-Hedging 399 19.5 Three Observations on Rebalancing Delta-Neutral Option Portfolios 400 19.6 Rebalancing Portfolios with Directional Exposures 401 19.7 Mean-Reversion and Diversification Return 407 19.8 Investment Monitoring 409 Chapter 20 Risk Measurement, Risk Management, and Risk Systems 413 20.1 Overview of Risk Measurement and Aggregation 413 20.2 Categories of Information to be Considered 422 20.3 Risk Measurement with Daily Frequency of Data Collection 424 20.4 Risk Measurement with Weekly Frequency of Data Collection 425 20.5 Risk Measurement with Monthly Frequency of Data Collection 426 20.6 Risk Measurement with Quarterly Frequency of Data Collection 427 20.7 Risk Measurement with Annual Frequency of Data Collection or Rolling Time Periods 427 20.8 Cybersecurity for Fund Managers 429 20.9 Risk Management Structure and Process 432 Part 5 Methods for Alternative Investing Chapter 21 Valuation and Hedging Using Binomial Trees 439 21.1 A One-Period Binomial Tree and Risk-Neutral Modeling 439 21.2 Multi-Period Binomial Trees, Values, and Mean Rates 442 21.3 Valuation of Convertible Securities with a Binomial Tree Model 445 21.4 Valuing Callable Bonds with a Tree Model 452 21.5 Tree Models, Visualization, and Two Benefits to Spreadsheets 458 Chapter 22 Directional Strategies and Methods 459 22.1 Efficiently Inefficient Markets 459 22.2 Technical Directional Strategies Overview 460 22.3 Fundamental Directional Strategies 467 22.4 Directional Strategies and Behavioral Finance 473 22.5 Directional Trading and Factors 476 Chapter 23 Multivariate Empirical Methods and Performance Persistence 479 23.1 Statistical Factors and Principal Component Analysis 479 23.2 Multi-Factor Models and Regression 483 23.3 Partial Autocorrelations and Regression 485 23.4 Three Dynamic Risk Exposure Models 487 23.5 Two Approaches to Modeling Changing Correlation 489 23.6 Four Multi-Factor Approaches to Understanding Returns 493 23.7 Evidence on Fund Performance Persistence 496 Chapter 24 Relative Value Methods 499 24.1 Overview of Relative Value Methods 499 24.2 Types of Pairs Trading and the Four Typical Steps 502 24.3 Statistical Pairs Trading of Equities 503 24.4 Pairs Trading in Commodity Markets Based on Spreads 506 Chapter 25 Valuation Methods for Private Assets: The Case of Real Estate 519 25.1 Depreciation Tax Shields 519 25.2 Deferral of Taxation of Gains 522 25.3 Comparing After-Tax Returns for Various Taxation Scenarios 524 25.4 Transaction-Based Indices: Repeat-Sales 529 25.5 Transaction-Based Indices: Hedonic 532 25.6 Sample Bias and the Repeat-Sales and Hedonic-Price Methods 535 25.7 Appraisal-Based Indices 536 25.8 Noisy Pricing 537 Part 6 Accessing Alternative Investments Chapter 26 Hedge Fund Replication 543 26.1 An Overview of Replication Products 543 26.2 Potential Benefits of Replication Products 544 26.3 The Case for Hedge Fund Replication 545 26.4 Unique Benefits of Replication Products 549 26.5 Factor-Based Approach to Replication 552 26.6 The Algorithmic (Bottom-Up) Approach 558 26.7 Three Illustrations of the Algorithmic (Bottom-Up) Approach 558 Chapter 27 Diversified Access to Hedge Funds 565 27.1 Evidence Regarding Hedge Fund Risk and Returns 565 27.2 Approaches to Accessing Hedge Funds 569 27.3 Characteristics of Funds of Hedge Funds 573 27.4 Fund of Hedge Funds Portfolio Construction 577 27.5 Ways that Funds of Hedge Funds Can Add Value 580 27.6 Investable Hedge Fund Indices 584 27.7 Alternative Mutual Funds 585 Chapter 28 Access to Real Estate and Commodities 589 28.1 Unlisted Real Estate Funds 589 28.2 Listed Real Estate Funds 594 28.3 Commodities 598 28.4 Commodity Trade Financing and Production Financing 606 28.5 Leveraged and Option-Based Structured Commodity Exposures 606 28.6 Key Concepts in Managing Commodity Exposure 609 Chapter 29 Access Through Private Structures 613 29.1 Overview of Issues in Private Versus Listed Investment Access 613 29.2 Unlisted Manager-Investor Relationships 616 29.3 Side Letters to Limited Partnership Agreements 619 29.4 Co-Investments 621 29.5 Cash Commitments and Illiquidity 626 29.6 The Secondary Market for PE Partnerships 629 Chapter 30 The Risk and Performance of Private and Listed Assets 637 30.1 Evidence on an Illiquidity Premium from Listed Assets 637 30.2 Private Versus Listed Real Performance: The Case of Real Estate 639 30.3 Challenges with the PME Method to Evaluating Private Asset Performance 641 30.4 Multiple Evaluation Tools 648 30.5 IRR Aggregation Problems for Portfolios 653 30.6 The Case Against Private Equity 657 30.7 Two Propositions Regarding Access Through Private Versus Listed Structures 658 Part 7 Due Diligence & Selecting Managers Chapter 31 Active Management and New Investments 663 31.1 Tactical Asset Allocation 663 31.2 The Fundamental Law of Active Management 664 31.3 Costs of Actively Reallocating Across Alternative Investments 667 31.4 Keys to a Successful Tactical Asset Allocation Process 670 31.5 Adjusting Exposures to Illiquid Partnerships 674 31.6 The Secondary Market for PE LP Interests 676 Chapter 32 Selection of a Fund Manager 683 32.1 The Importance of Fund Selection Across Managers Through Time 683 32.2 The Relationship Life Cycle Between LPs and GPs 683 32.3 Fund Return Persistence 688 32.4 Moral Hazard, Adverse Selection, and the Holdup Problem in Fund Management 694 32.5 Screening with Fundamental Questions 694 32.6 Historical Performance Review 698 32.7 Manager Selection and Deal Sourcing 703 32.8 Fund Culture 705 32.9 Decision-Making and Commitment and Manager Selection 706 Chapter 33 Investment Process Due Diligence 709 33.1 Overview of Investment Due Diligence 709 33.2 The Investment Strategy or Mandate 712 33.3 The Investment Implementation Process and its Risks 715 33.4 Asset Custody and Valuation 717 33.5 Risk Alert's One Advantage and Six Observations on Third-Party Information 723 33.6 Portfolio Risk Review 725 33.7 Four Warning Indicators and Awareness Signals Regarding Investments 729 33.8 Four Warning Indicators and Awareness Signals Regarding Risk Management 729 Chapter 34 Operational Due Diligence 731 34.1 Operations: Overview, Risks, and Remedies 731 34.2 Four Key Operational Activities 735 34.3 Analyzing Fund Cash Management and Movement 737 34.4 Analyzing External Parties and Checking Principals 739 34.5 Analyzing Fund Compliance 743 34.6 Onsite Manager Visits 747 34.7 Elements and Key Concerns of the Odd Process 748 34.8 Information Technology and Meta Risks 749 34.9 Funding, Applying, and Concluding ODD 750 Chapter 35 Due Diligence of Terms and Business Activities 755 35.1 Due Diligence Document Collection Process 755 35.2 Fund Governance 757 35.3 Structural Review of the Fund And Fund Manager 758 35.4 Terms for Liquid Private Funds 761 35.5 Terms for Illiquid Private Funds 763 35.6 General Terms for Private Funds 764 35.7 Private Placement Memorandum (PPM) 765 35.8 Fund Fees and Expenses 769 35.9 Private Fund Audited Financial Statement Review 771 35.10 Business Activities, Continuity Planning, Disaster Recovery, and Insurance 773 Part 8 Volatility and Complex Strategies Chapter 36 Volatility as a Factor Exposure 779 36.1 Measures of Volatility 779 36.2 Volatility and the Vegas, Gammas, and Thetas of Options 781 36.3 Exposures to Volatility as a Factor 785 36.4 Modeling Volatility Processes 791 36.5 Implied Volatility Structures 794 Chapter 37 Volatility, Correlation, and Dispersion Products and Strategies 799 37.1 Common Option Strategies and their Volatility Exposures 799 37.2 Volatility and Delta-Neutral Portfolios with Options 803 37.3 Advanced Option-Based Volatility Strategies 805 37.4 Variance-Based and Volatility-Based Derivative Products 807 37.5 Correlation Swaps 815 37.6 Dispersion Trades 818 37.7 Summary and Common Themes of Volatility, Correlation, and Dispersion Trading 819 Chapter 38 Complexity and Structured Products 825 38.1 Uncertainty, Ambiguity, and Opacity 825 38.2 Asset and Strategy Complexity 827 38.3 Cases in Complexity and Perverse Incentives 828 38.4 Asset-Based Lending 831 38.5 Risks of Asset-Based Loans 836 38.6 Asset-Backed Securities 838 Chapter 39 Insurance-Linked Products and Hybrid Securities 845 39.1 Nonlife ILS: Catastrophe Bonds 845 39.2 Four Trigger Types of Cat Bonds 847 39.3 Cat Bond Valuation, Performance, and Drawbacks 849 39.4 Longevity and Mortality Risk-Related Products 852 39.5 Life Insurance Settlements 855 39.6 Overview of Viatical Settlements 857 39.7 Hybrid Products: Mezzanine Debt 859 Chapter 40 Complexity and the Case of Cross-Border Real Estate Investing 865 40.1 Traditional View of Currency-Hedging for Cross-Border Real Estate Investing 865 40.2 Fundamentals of Currency Risk And Hedging in Perfect Markets 870 40.3 Currency Risk and Hedging of Alternative Investments 873 40.4 Accessing Foreign Assets with Futures and Quanto Futures 876 40.5 Overview of International Real Estate Investing 879 40.6 Heterogenous Investment Taxation Across Jurisdictions 881 40.7 Challenges to International Real Estate Investing 882 Index 887

DR. DONALD R. CHAMBERS, PhD, CAIA, is Associate Director of Programs at the CAIA Association; Chief Investment Officer of Biltmore Capital Advisors and Emeritus Professor at Lafayette College in Easton, Pennsylvania. Dr. Chambers previously served as Director of Alternative Investments at Karpus Investment Management. He is a member of the editorial board of The Journal of Alternative Investments. DR. HOSSEIN KAZEMI, PhD, is a senior adviser to the CAIA Association. He is the Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts, Amherst; Director of the Center for International Securities and Derivatives Markets; a cofounder of the CAIA Association; and Editor-in-Chief of The Journal of Alternative Investments-the official publication of the CAIA Association and a member of the editorial board of The Journal of Financial Data Science. DR. KEITH H. BLACK, PhD, CAIA, FDP, is the Managing Director of Content Strategy at the CAIA Association. He was previously an associate at Ennis Knupp and, before that, an assistant professor at Illinois Institute of Technology. He is a member of the editorial board of The Journal of Alternative Investments.