Title Details

HOSSEIN B. KAZEMI, PhD, is a co-founder of and the Senior Advisor for the CAIA Association. Dr. Kazemi is the Michael and Cheryl Philipp Distinguished Professor of Finance at Isenberg School of Management, the University of Massachusetts Amherst, the Director of the Center for International Securities and Derivatives Markets, and editor of the Journal of Alternative Invest-ments and Alternative Investment Analyst Review.

KEITH H. BLACK, PhD, CAIA, is a Managing Director at the CAIA Association, overseeing curriculum and exam development for the 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.

DONALD R. CHAMBERS, PhD, CAIA, is Associ-ate Director of Programs at the CAIA Association and the Walter E. Hanson/KPMG Professor of Finance at Lafayette College in Easton, Pennsylvania. Dr. Chambers currently serves as the CIO for Biltmore Capital Advisors and served as the Director of Alternative investments at Karpus Investment Management. He is a member of the editorial board of the Journal of Alternative Investments.

Acknowledgments xxi

About the Authors xxiii

PART 1 Asset Allocation and Institutional Investors

CHAPTER 1 Asset Allocation Processes and the Mean-Variance Model 3

1.1 Importance of Asset Allocation 3

1.2 The Five Steps of the Asset Allocation Process 6

1.3 Asset Owners 7

1.4 Objectives and Constraints 9

1.5 Investment Policy Objectives 9

1.6 Investment Policy Constraints 17

1.7 Preparing an Investment Policy Statement 18

1.8 Implementation 22

1.9 Conclusion 33

Notes 34

References 34

CHAPTER 2 Tactical Asset Allocation, Mean-Variance Extensions, Risk Budgeting, Risk Parity, and Factor Investing 35

2.1 Tactical Asset Allocation 35

2.2 Extensions to the Mean-Variance Approach 45

2.3 Risk Budgeting 50

2.4 Risk Parity 55

2.5 Factor Investing 62

2.6 Conclusion 68

Notes 69

References 69

CHAPTER 3 The Endowment Model 71

3.1 Defining Endowments and Foundations 71

3.2 Intergenerational Equity, Inflation, and Spending Challenges 74

3.3 The Endowment Model 76

3.4 Why Might Large Endowments Outperform? 78

3.5 Risks of the Endowment Model 84

3.6 Conclusion 96

Note 96

References 96

CHAPTER 4 Pension Fund Portfolio Management 99

4.1 Development,Motivations, and Types of Pension Plans 99

4.2 Risk Tolerance and Asset Allocation 101

4.3 Defined Benefit Plans 105

4.4 Governmental Social Security Plans 113

4.5 Contrasting Defined Benefit and Contribution Plans 114

4.6 Annuities for Retirement Income 117

4.7 Conclusion 122

Notes 122

References 122

CHAPTER 5 Sovereign Wealth Funds 125

5.1 Sources of Sovereign Wealth 125

5.2 Four Types of Sovereign Wealth Funds 128

5.3 Establishment and Management of Sovereign Wealth Funds 131

5.4 Emergence of Sovereign Wealth Funds 134

5.5 Governance and Political Risks of SWFs 136

5.6 Analysis of Three Sovereign Wealth Funds 138

5.7 Conclusion 141

Notes 142

References 142

CHAPTER 6 The Family Office Model 145

6.1 Identifying Family Offices 145

6.2 Goals, Benefits, and Business Models of Family Offices 145

6.3 Family Office Goals by Generations 150

6.4 Macroeconomic Exposures of Family Offices 155

6.5 Income Taxes of Family Offices 157

6.6 Lifestyle Assets of Family Offices 160

6.7 Family Office Governance 164

6.8 Charity, Philanthropy, and Impact Investing 167

6.9 Ten Competitive Advantages of Family Offices 170

6.10 Conclusion 172

Notes 172

References 173

PART 2 Private Equity

CHAPTER 7 Private Equity Market Structure 177

7.1 Main Strategies of Private Equity Investment 177

7.2 Main Differences between Venture Capital and Buyout 178

7.3 PE Funds as Intermediaries 181

7.4 PE Funds of Funds as Intermediaries 184

7.5 The Relationship Life Cycle between LPs and GPs 187

7.6 Limited Partnership Key Features 190

7.7 Co-Investments 198

7.8 Conclusion 202

Notes 202

References 203

CHAPTER 8 Private Equity Benchmarking 205

8.1 The Valuation of PE Assets 206

8.2 Measuring Performance of PE Funds 206

8.3 Benchmark Types 212

8.4 Asset-Based Benchmarks 213

8.5 Peer Groups 215

8.6 What Is an Appropriate Benchmark? 218

8.7 Example for Benchmarking PE Funds 220

8.8 Portfolio of PE Funds 226

8.9 Conclusion 231

Notes 232

References 232

CHAPTER 9 Fund Manager Selection and Monitoring 235

9.1 Performance Persistence 235

9.2 Manager Selection and Deal Sourcing 241

9.3 Decision-Making and Commitment 244

9.4 Principles of Fund Monitoring 245

9.5 Monitoring Objectives 246

9.6 Information Gathering and Monitoring 248

9.7 Actions Resulting from Monitoring 251

9.8 The Secondary Market 253

9.9 Conclusion 259

Notes 260

References 262

CHAPTER 10 Private Equity Operational Due Diligence 265

10.1 The Scope and Importance of Operational Due Diligence 265

10.2 Eight Core Elements of the Operational Due Diligence Process 268

10.3 Private Equity Operational Due Diligence Document Collection Process 269

10.4 Analyzing Private Equity Legal Documentation during Operational Due Diligence 272

10.5 Operational Due Diligence beyond Legal Document Analysis 278

10.6 On-Site Manager Visits 282

10.7 Evaluating Meta Risk 284

10.8 Fund Service Provider Review and Confirmation 285

10.9 Ongoing Private Equity Monitoring Considerations 286

10.10 Conclusion 287

Notes 288

References and Further Readings 288

CHAPTER 11 Private Equity Investment Process and Portfolio Management 289

11.1 Investment Process 290

11.2 Private Equity Portfolio: Design 293

11.3 Private Equity Portfolio: Construction 297

11.4 Risk-Return Management 300

11.5 Conclusion 306

Notes 307

References 308

CHAPTER 12 Measuring Private Equity Risk 309

12.1 Four Significant Risks of Private Equity 309

12.2 Modeling Private Equity 311

12.3 What Is the Value of a Private Equity Asset? 313

12.4 Applying the VaR Concept to Private Equity 315

12.5 Calculating VaR Based on Cash Flow at Risk 315

12.6 Conclusion 320

Notes 321

References 321

CHAPTER 13 The Management of Liquidity 323

13.1 Identifying Illiquidity and Managing Cash Flows 323

13.2 Private Equity Cash Flow Schedules 327

13.3 Five Sources of Liquidity 328

13.4 Investment Strategies for Undrawn Capital 330

13.5 Modeling Cash Flow Projections 330

13.6 Three Approaches to Forming Model Projections 331

13.7 Overcommitment 337

13.8 Conclusion 339

Notes 340

References 340

PART 3 Real Assets

CHAPTER 14 Real Estate as an Investment 343

14.1 Attributes of Real Estate 343

14.2 Asset Allocation 345

14.3 Categories of Real Estate 347

14.4 Return Drivers of Real Estate 352

14.5 The Four-Quadrant Model 354

14.6 Conclusion 358

Note 358

References 358

CHAPTER 15 Real Estate Indices and Unsmoothing Techniques 361

15.1 Smoothed Pricing 362

15.2 Models of Price and Return Smoothing 365

15.3 Unsmoothing a Price or Return Series 368

15.4 An Illustration of Unsmoothing 372

15.5 Noisy Pricing 378

15.6 Appraisal-Based Real Estate Indexes 379

15.7 Transaction-Based Indices (Repeat-Sales and Hedonic) 384

15.8 Description of Major Real Estate Indices 390

15.9 Real Estate Indices Performance 393

15.10 Conclusion 398

Notes 398

References 399

CHAPTER 16 Investment Styles, Portfolio Allocation, and Real Estate Derivatives 401

16.1 Defining the Three NCREIF Real Estate Styles 402

16.2 Differentiating Styles with Eight Attributes 404

16.3 Three Purposes of Real Estate Style Analysis 404

16.4 Real Estate Style Boxes 407

16.5 Cap Rates and Expected Returns 408

16.6 Developing Risk and Return Expectations with Styles 409

16.7 Characteristics of Real Estate Derivatives 415

16.8 Types of Real Estate Derivatives and Indices 417

16.9 Conclusion 421

References 421

CHAPTER 17 Listed versus Unlisted Real Estate Investments 423

17.1 Unlisted Real Estate Funds 423

17.2 Listed Real Estate Funds 427

17.3 Market-Based versus Appraisal-Based Returns 435

17.4 Arbitrage, Liquidity, and Segmentation 439

17.5 Conclusion 448

Note 449

References 449

CHAPTER 18 International Real Estate Investments 451

18.1 Overview of International Real Estate Investing 451

18.2 Opportunities in International Real Estate Investing 453

18.3 Challenges to International Real Estate Investing 462

18.4 Establishing a Global Real Estate Equity Investment Program 470

18.5 Conclusion 476

Note 476

References 477

CHAPTER 19 Infrastructure as an Investment 479

19.1 Infrastructure Assets 479

19.2 Stage, Location, and Sector of Infrastructure 483

19.3 Twelve Attributes of Infrastructure as Defensive Investments 486

19.4 Accessing Infrastructure Investment Opportunities 489

19.5 Classifying Infrastructure Fund Strategies 493

19.6 Comparison of Infrastructure with Other Assets 496

19.7 Public-Private Partnerships 497

19.8 Infrastructure Regulation and Public Policy 499

19.9 Infrastructure Historical Performance 499

19.10 Conclusion 501

References 502

CHAPTER 20 Farmland and Timber Investments 503

20.1 Motivations for and Characteristics of Farmland Investment 503

20.2 Global Demand for Agricultural Products 505

20.3 Accessing Agricultural Returns 508

20.4 Understanding the Returns to Farmland 514

20.5 Investing in Agricultural Infrastructure 520

20.6 Global Investing in Timberland 522

20.7 Farmland and Timber Investments Compared to Other Real Assets 525

20.8 Key Points 528

20.9 Conclusion 529

Notes 529

References 529

CHAPTER 21 Investing in Intellectual Property 533

21.1 Characteristics of Intellectual Property 533

21.2 Film Production and Distribution 534

21.3 Visual Works of Art 541

21.4 R&D and Patents 546

21.5 Intellectual Property and Six Characteristics of Real Assets 552

21.6 Conclusion 553

Notes 553

References 555

PART 4 Commodities

CHAPTER 22 Key Concepts in Commodity Markets 561

22.1 Economics of Commodity Spot Markets 561

22.2 Commodity Trading Firms, Risks, and Speculation 565

22.3 Economics of Commodity Futures Markets 570

22.4 Theories of Commodity Forward Curves 575

22.5 Decomposition of Returns to Futures-Based Commodity Investment 581

22.6 Commodities as an Inflation Hedge 582

22.7 Commodities and Exchange Rates 584

22.8 Rebalancing and Historical Performance of Commodity Futures 586

22.9 Conclusion 590

Notes 590

References 591

CHAPTER 23 Allocation to Commodities 593

23.1 Five Beneficial Characteristics of Allocations to Commodity Futures 593

23.2 Commodity Investment Strategies 602

23.3 Directional Strategies 602

23.4 Relative Value Strategies 605

23.5 Commodity Futures and Options Spreads 605

23.6 Capital Structure and Commodity-Based Corporations 612

23.7 Conclusion 614

Notes 615

References 615

CHAPTER 24 Accessing Commodity Investment Products 619

24.1 Direct Physical Ownership of Commodities 619

24.2 Indirect Ownership of Commodities 620

24.3 Leveraged and Option-Based Structures 628

24.4 Commodity Index Basics 631

24.5 Eight Sources of Commodity Index Returns 631

24.6 Issues in Commodity Index Design 634

24.7 Performance Enhancements of New Commodity Indices 637

24.8 Commodity Index Return Calculation 639

24.9 Conclusion 644

Notes 644

References 645

PART 5 Hedge Funds and Managed Futures

CHAPTER 25 Managed Futures 649

25.1 The Structure of the Managed Futures Industry 649

25.2 Four Core Dimensions of Managed Futures Investment Strategies 651

25.3 Foundations of Managed Futures 658

25.4 Benefits of CTAs 666

25.5 Systematic Futures Portfolio Construction 671

25.6 Conclusion 675

References 676

CHAPTER 26 Investing in CTAs 677

26.1 Historical Performance of CTAs 677

26.2 Diversification Benefits of CTAs 685

26.3 CTA Risk Measurement and Risk Management 688

26.4 Three Approaches to the Benchmarking of CTAs 700

26.5 Managed Accounts and Platforms 703

26.6 Conclusion 707

Notes 709

References 709

CHAPTER 27 Relative Value Strategies 711

27.1 Limits to Arbitrage of Relative Valuation 711

27.2 Convertible Arbitrage: An Overview 717

27.3 Pairs Trading and Market Neutrality 733

27.4 Conclusion 741

Notes 743

References 743

CHAPTER 28 Hedge Funds: Directional Strategies 745

28.1 Financial Economics of Directional Strategies 745

28.2 Equity Long/Short 751

28.3 Global Macro 769

28.4 Historical Performance of Directional Strategies 785

28.5 Conclusion 786

Notes 786

References 786

CHAPTER 29 Hedge Funds: Credit Strategies 789

29.1 The Economics of Credit Risk 789

29.2 Overview of Credit Risk Modeling 792

29.3 The Merton Model 793

29.4 Other Structural Models—KMV 798

29.5 Reduced-Form Models 801

29.6 Pros and Cons of Structural and Reduced-Form Models 805

29.7 Empirical Credit Models 805

29.8 Distressed Debt Investment Strategy 808

29.9 Bankruptcy Laws across the Globe 815

29.10 Implementation of Distressed Debt Strategies 819

29.11 Valuation Risks in Distressed Debt Investing 822

29.12 Asset-Based Lending 824

29.13 Conclusion 830

Notes 830

References 830

CHAPTER 30 Volatility, Correlation, and Dispersion Products and Strategies 833

30.1 Volatility, Risk Factors, and Risk Premiums 833

30.2 Using Options to Manage Portfolio Volatility Exposure and Risk Premiums 835

30.3 Modeling Volatility Processes 845

30.4 Volatility Products 848

30.5 Option-Based Volatility Strategies 855

30.6 Volatility Hedge Funds and Their Strategies 859

30.7 Conclusion 865

Notes 865

References 866

CHAPTER 31 Hedge Fund Replication 867

31.1 An Overview of Replication Products 867

31.2 Potential Benefits of Replication Products 868

31.3 The Case for Hedge Fund Replication 869

31.4 Unique Benefits of Replication Products 873

31.5 Factor-Based Approach to Replication 877

31.6 Payoff-Distribution Approach 882

31.7 Algorithmic (Bottom-Up) Approach 885

31.8 Alternative Mutual Funds 890

31.9 Exchange-Traded Funds 893

31.10 Conclusion 894

Notes 895

References 895

CHAPTER 32 Funds of Hedge Funds and Multistrategy Funds 897

32.1 Approaches to Accessing Hedge Funds 897

32.2 Characteristics of Funds of Hedge Funds 901

32.3 Funds of Funds Performance 905

32.4 Fund of Hedge Funds Portfolio Construction 907

32.5 Manager Selection 913

32.6 Benefits Offered by Funds of Hedge Funds 914

32.7 Disadvantages of Funds of Hedge Funds 916

32.8 Funds of Hedge Funds versus Multistrategy Funds 917

32.9 How Funds of Hedge Funds Add Value 919

32.10 Hedge Funds Indices 925

32.11 Conclusion 929

References 930

CHAPTER 33 Hedge Fund Operational Due Diligence 933

33.1 Distinguishing Hedge Fund and Private Equity Operational Due Diligence 933

33.2 Four Operational Steps in Analyzing Hedge Fund Operational Trading Procedures 934

33.3 Analyzing Hedge Fund Cash Management and Movement 936

33.4 Analyzing Hedge Fund External Parties 938

33.5 Analyzing Hedge Fund Compliance Considerations 942

33.6 Documenting the Operational Due Diligence Process 945

33.7 Operational Decision Making and Allocation Considerations 946

33.8 Investigative Due Diligence 948

33.9 Four Approaches to Resource Allocation for Operational Due Diligence 950

33.10 Hedge Fund Governance 952

33.11 Hedge Fund Insurance 954

33.12 Performing Operational Due Diligence on Funds of Hedge Funds 955

33.13 Conclusion 956

CHAPTER 34 Regulation and Compliance 957

34.1 Three Foundational Principles of Financial Market Regulation 957

34.2 The Regulation of Alternative Investments within the United States 958

34.3 Alternative Investment Regulation in Europe 969

34.4 Hedge Fund Regulation in Asia 979

34.5 Conclusion 983

Notes 983

PART 6 Structured Products

CHAPTER 35 Structured Products-I Fixed-Income Derivatives and Asset-Backed Securities 991

35.1 Overview of Term Structure Modeling 991

35.2 Equilibrium Models of the Term Structure 992

35.3 Arbitrage-Free Models of the Term Structure 996

35.4 Interest Rate Derivatives 999

35.5 Asset-Backed Securities 1013

35.6 Auto Loan–Backed Securities 1014

35.7 Credit Card Receivables 1016

35.8 Conclusion 1018

Notes 1018

References 1018

CHAPTER 36 Structured Products II: Insurance-Linked Products and Hybrid Securities 1021

36.1 Insurance-Linked Securities 1021

36.2 Overview of Non-Life ILS: Catastrophe Bonds 1021

36.3 Life ILS: Longevity and Mortality Risk–Related Products 1030

36.4 Hybrid Products: Mezzanine Debt 1037

36.5 Conclusion 1050

Notes 1051

References 1051

Appendix A

Alternative Presentations of Mean-Variance Optimization 1053

Index 1055