Risk Factors, Expected Returns, and Investment Instruments

When considering investments in alternative asset classes beyond risk, return, and correlation, practical complexities must be addressed. Neglecting these distinctions between traditional and alternative investments can jeopardize an investment strategy. Key factors to contemplate include:

• Defining risk characteristics: Understand the unique risk profiles.
• Setting return expectations: Anticipate performance realistically.
• Choosing the right investment vehicle: Select an appropriate instrument.
• Managing operational liquidity: Address liquidity issues.
• Evaluating expenses and fees: Assess cost considerations.
• Navigating tax implications: Account for tax considerations (relevant for taxable entities).
• Other factors: Additional relevant aspects.

Properly Defining Risk Characteristics

Properly defining risk characteristics is crucial. Mean-variance optimization, relying on standard deviation, may not suit alternative investments due to infrequent valuation, erratic correlations, and extended lock-up periods. Modeling alternative portfolios is beneficial but may not fully elucidate their behavior. Specific issues arise in risk-based analysis:

• Short-only funds: Unlike long-only funds with limited downside and unlimited upside, short-only funds have the reverse risk-reward profile, posing modeling challenges.
• Call option strategies: Hedge funds may employ diverse call options with differing payouts, making modeling based solely on historical return data less useful.

Establishing Return Expectations

Determining expected returns for alternative investments is challenging due to their limited return history and idiosyncratic nature. There’s no one-size-fits-all approach. A “building blocks” method can be used:

• Begin with the risk-free rate.
• Add estimated returns linked to relevant factor exposures (e.g., credit spreads, yield curve, equity, liquidity).
• Incorporate assumptions for manager alpha.
• Subtract appropriate fees (management and incentive) and taxes.

Selection of the Appropriate Investment Vehicle

Direct investment in a Limited Partnership

This is the primary form of alternative investment requiring substantial initial investments. General Partners (investors) risk only the capital they contribute but must avoid excessive involvement in fund management to maintain limited liability.

Using FOFs

This is ideal for smaller investors who don’t meet minimum funding requirements. FOFs aggregate direct investments in alternatives, offering expertise in managing and monitoring underlying funds and portfolios. However, they often come with additional fees.

SMAs (Fund of One)

Portfolios managed by professional firms, usually available to wealthier retail clients. SMAs provide customization in investment strategy, direct ownership of securities, and tax advantages. They may involve wrap fees of 1%-3% annually.

Mutual funds/UCITS/publicly traded funds

Nominally, Mutual funds and UCITS allow smaller investors to access asset classes otherwise unavailable. Regulatory restrictions limit their ability to implement investment strategies like hedge funds. Managers must register with regulatory authorities and provide publicly reviewed financial statements.

Operational liquidity issues

Traditional investments are typically highly liquid, while alternative investments can introduce illiquidity both at the fund and asset levels. For instance, some funds may impose a 7-year lock-up period, and investments in non-G7 currencies can lack liquidity.

Expense and Fee Considerations

Funds with call-down structures, like private equity funds, where fees are based on committed capital, can be particularly fee-sensitive. The classic 2/20 fee model involves a 2% annual fee on assets under management and a 20% fee on profits. Additionally, most alternative investment funds pass through standard expenses, including legal, custodial, audit, administration, and accounting fees (the 2% portion of 2/20).

Tax Considerations (applicable for taxable entities)

Investors in alternative investments must focus on after-tax returns, especially with strategies generating significant short-term gains or high taxable income. A cost-benefit analysis is essential, considering taxable equivalent yield and other factors. Different jurisdictions have unique tax rules for investment gains; for example, in the US, real estate, timber, and energy investments enjoy preferential tax treatment.

Other Considerations

Smaller investors often rely on FOFs or intermediaries, while larger portfolios offer more choices. Key questions for investors:

• Can they access top-tier managers in their chosen strategy?
• Do they have the information needed for due diligence?
• Are they equipped to evaluate and monitor an alternative investment program effectively?

Question

From a risk analysis standpoint, investment in a short-only hedge fund can be most accurately described as carrying what kind of profit potential?

1. Limited gain; unlimited loss.
2. Unlimited gain; limited loss.
3. Limited gain; limited loss.

Solution

The correct answer is A.

This choice accurately describes the typical risk profile of a short-only strategy. When an investor shorts a security (sells it without owning it), the maximum potential gain is limited to the price at which the security was sold. However, the potential loss is theoretically unlimited since the security’s price can rise significantly. If the security’s price increases, the short seller incurs losses as they must eventually buy the security at a higher price to cover their position.

B is incorrect. This choice does not accurately describe the risk profile of a short-only strategy. Shorting a security involves a limited gain potential (the initial selling price) and potentially unlimited losses if the security’s price increases significantly. So, “unlimited gain” is not accurate.

C is incorrect. This choice also does not accurately describe the risk profile of a short-only strategy. While the potential gain is limited to the initial selling price, the potential loss is not limited. If the security’s price increases, losses can accrue, making the loss potential unlimited, not limited.

Portfolio Construction: Learning Module 3: Asset Allocation to Alternative Investments; Los 3(d) Discuss investment considerations that are important in allocating to different types of alternative investments