Contents

Cover

Series

Title Page

Copyright

Preface

TEN YEARS OF CAIA AND ALTERNATIVE INVESTMENTS

THE HISTORY OF CAIA

BENEFITS OF THE CAIA PROGRAM

STUDYING FOR THE CAIA EXAMS

Acknowledgments

About the Authors

Chapter 1: Introduction

1.1 OUTLINE OF THIS BOOK

1.2 STUDYING FOR THE CAIA LEVEL II EXAMINATION

PART One: Asset Allocation and Portfolio Management

Chapter 2: The Endowment Model

2.1 DEFINING ENDOWMENTS AND FOUNDATIONS

2.2 INTERGENERATIONAL EQUITY, INFLATION, AND SPENDING CHALLENGES

2.3 THE ENDOWMENT MODEL

2.4 WHY MIGHT LARGE ENDOWMENTS OUTPERFORM?

2.5 CONCLUSION

Chapter 3: Risk Management for Endowment and Foundation Portfolios

3.1 SPENDING RATES AND INFLATION

3.2 LIQUIDITY ISSUES

3.3 REBALANCING AND TACTICAL ASSET ALLOCATION

3.4 TAIL RISK

3.5 CONCLUSION

Chapter 4: Pension Fund Portfolio Management

4.1 DEFINED BENEFIT PLANS

4.2 GOVERNMENTAL SOCIAL SECURITY PLANS

4.3 DEFINED CONTRIBUTION PLANS

PART Two: Private Equity

Chapter 5: Private Equity Market Landscape

5.1 MAIN STRATEGIES

5.2 MAIN DIFFERENCES BETWEEN VENTURE CAPITAL AND BUYOUT

5.3 PRIVATE EQUITY FUNDS AS INTERMEDIARIES

5.4 PRIVATE EQUITY FUNDS OF FUNDS AS INTERMEDIARIES

5.5 PRIVATE EQUITY FUNDS OF FUNDS VALUE-ADDED

5.6 THE RELATIONSHIP LIFE CYCLE BETWEEN LIMITED AND GENERAL PARTNERS

5.7 THE J-CURVE

5.8 CONCLUSION

Chapter 6: Private Equity Fund Structure*

6.1 KEY FEATURES

6.2 CONFLICTS OF INTEREST

6.3 FINDING THE BALANCE

Chapter 7: The Investment Process

7.1 PROCESS DESCRIPTION

7.2 RISK MANAGEMENT

Chapter 8: Private Equity Portfolio Design

8.1 THREE APPROACHES TO PRIVATE EQUITY PORTFOLIO DESIGN

8.2 RISK-RETURN MANAGEMENT APPROACHES

8.3 THE RISK PROFILE OF PRIVATE EQUITY ASSETS

Chapter 9: Fund Manager Selection Process

9.1 DETERMINATION OF THE WISH LIST OF FUND CHARACTERISTICS

9.2 DEAL SOURCING

9.3 DUE DILIGENCE: IMPORTANCE AND LIMITATIONS

9.4 DECISION AND COMMITMENT

Chapter 10: Measuring Performance and Benchmarking in the Private Equity World

10.1 INDIVIDUAL FUNDS

10.2 PORTFOLIO OF FUNDS

Chapter 11: Monitoring Private Equity Fund Investments

11.1 APPROACH TO MONITORING

11.2 THE MONITORING OBJECTIVES

11.3 INFORMATION GATHERING IN THE MONITORING PROCESS

11.4 ACTIONS RESULTING FROM MONITORING

Chapter 12: Private Equity Fund Valuation

12.1 NET ASSET VALUE (NAV)

12.2 INTERNAL RATE OF RETURN (IRR)

12.3 ECONOMIC VALUE APPROACH

Chapter 13: Private Equity Fund Discount Rates

13.1 THE CAPITAL ASSET PRICING MODEL (CAPM)

13.2 PRIVATE EQUITY FUND BETAS

Chapter 14: The Management of Liquidity

14.1 PRIVATE EQUITY CASH FLOW SCHEDULES

14.2 SOURCES OF LIQUIDITY

14.3 INVESTMENT STRATEGIES FOR UNDRAWN CAPITAL

14.4 CASH FLOW PROJECTIONS

14.5 OVERCOMMITMENT

14.6 CONCLUSION

PART Three: Real Assets

Chapter 15: Real Estate as an Investment

15.1 ATTRIBUTES OF REAL ESTATE

15.2 ASSET ALLOCATION

15.3 CATEGORIES OF REAL ESTATE

15.4 RETURN DRIVERS OF REAL ESTATE

Chapter 16: Unsmoothing of Appraisal-Based Returns

16.1 SMOOTHED PRICING

16.2 MODELS OF PRICE AND RETURN SMOOTHING

16.3 UNSMOOTHING A PRICE OR RETURN SERIES

16.4 AN ILLUSTRATION OF UNSMOOTHING

Chapter 17: Core, Value-Added, and Opportunistic Real Estate

17.1 DEFINING THE THREE NCREIF REAL ESTATE STYLES

17.2 DIFFERENTIATING STYLES WITH ATTRIBUTES

17.3 PURPOSES OF REAL ESTATE STYLE ANALYSIS

17.4 REAL ESTATE STYLE BOXES

17.5 CAP RATES AND EXPECTED RETURNS

17.6 DEVELOPING RISK AND RETURN EXPECTATIONS WITH STYLES

Chapter 18: Real Estate Indices

18.1 THE MECHANICS OF APPRAISAL-BASED INDICES

18.2 NON-APPRAISAL-BASED INDICES

18.3 DESCRIPTION OF MAJOR REAL ESTATE INDICES

Chapter 19: Public versus Private Real Estate Risks

19.1 MARKET-BASED VERSUS APPRAISAL-BASED RETURNS

19.2 ARBITRAGE, LIQUIDITY, AND SEGMENTATION

19.3 PUBLIC REAL ESTATE PRODUCTS

Chapter 20: Portfolio Allocation within Real Estate

20.1 INCOME TAXATION

20.2 Leverage

20.3 Agency Relationships

20.4 Information Asymmetries

20.5 Liquidity and Transaction Costs

20.6 Cross-Border Real Estate Investment

20.7 Summary and Conclusions

Chapter 21: Farmland and Timber Investments*

21.1 GLOBAL DEMAND FOR AGRICULTURAL PRODUCTS

21.2 ACCESSING AGRICULTURAL RETURNS

21.3 UNDERSTANDING THE RETURNS TO FARMLAND

21.4 COMMODITY PRICE VOLATILITY AND ITS IMPLICATION FOR FARMLAND-BASED INVESTMENT STRATEGIES

21.5 GLOBAL INVESTING IN TIMBERLAND

21.6 KEY POINTS AND SUMMARY CONCLUSIONS

Chapter 22: Investing in Intellectual Property*

22.1 CHARACTERISTICS OF INTELLECTUAL PROPERTY

22.2 FILM PRODUCTION AND DISTRIBUTION

22.3 ART AS AN INVESTMENT ASSET

22.4 R&D AND PATENTS

22.5 CONCLUSION

Part Four: Commodities

Chapter 23: Key Concepts in Commodity Market Analysis

23.1 INTRODUCTION

23.2 REAL ASSETS AND FINANCIAL ASSETS

23.3 THE ROLE OF INVESTORS IN COMMODITY MARKETS

23.4 CONVENIENCE YIELD

23.5 COST OF CARRY

23.6 THEORIES OF COMMODITY FORWARD CURVES

Chapter 24: Role of Commodities in Asset Allocation

24.1 INTRODUCTION

24.2 REVIEW OF MAJOR ARTICLES AND STUDIES

24.3 SOURCES OF RETURN TO FUTURES-BASED COMMODITY INVESTMENT

24.4 THE STATISTICAL PROPERTIES OF COMMODITY PRICES

24.5 ASSET ALLOCATION

Chapter 25: Methods of Delivering Commodity Alpha

25.1 INTRODUCTION

25.2 DIRECTIONAL STRATEGIES

25.3 RELATIVE VALUE STRATEGIES

25.4 COMMODITY-BASED EQUITY AND DEBT STRATEGIES

25.5 FUNDAMENTAL ANALYSIS FOR DIRECTIONAL AND RELATIVE VALUE STRATEGIES

25.6 LOOKING FORWARD

Chapter 26: Methods of Delivering Commodity Beta: Indices, Swaps, Notes, and Hedge Funds

26.1 INTRODUCTION

26.2 DIRECT PHYSICAL OWNERSHIP OF COMMODITIES

26.3 INDIRECT OWNERSHIP OF COMMODITIES

26.4 LEVERAGED AND OPTION-BASED STRUCTURES

26.5 COMMODITY INDICES COMPARED TO SECURITIES INDICES

26.6 SOURCES OF COMMODITY INDEX RETURNS

26.7 ISSUES IN COMMODITY INDEX DESIGN

26.8 PERFORMANCE ENHANCEMENTS OF ENHANCED COMMODITY INDICES

26.9 A PRIMER ON COMMODITY INDEX CALCULATION: SPOT, ROLL, EXCESS, AND TOTAL RETURNS

Chapter 27: Macroeconomic Determinants of Commodity Futures Returns

27.1 COMMODITIES AS AN INFLATION HEDGE

27.2 COMMODITIES AND EXCHANGE RATES

27.3 COMMODITIES AND THE BUSINESS CYCLE

27.4 CONCLUSION

Chapter 28: Effective Risk Management Strategies for Commodity Portfolios*

28.1 MARKING THE NET ASSET VALUE

28.2 MEASURING EVENT RISKS

28.3 STRESS TESTING USING VALUE AT RISK

28.4 MEASURING LIQUIDITY RISKS

28.5 PERFORMANCE ATTRIBUTION

28.6 MITIGATING OPERATIONAL RISKS

28.7 CONCLUSION

Part Five: Real Assets

Chapter 29: Structure of the Managed Futures Industry

29.1 INVESTING IN CTAs AND CPOs

29.2 INDUSTRY REGULATION

29.3 BENEFITS OF CTAs

29.4 MARGIN REQUIREMENTS

29.5 UNDERSTANDING RETURNS

29.6 FOREIGN CURRENCY EXPOSURE

29.7 COLLATERAL INCOME AND SEGREGATION ISSUES

29.8 MARGIN-TO-EQUITY RATIOS

29.9 CONCLUSION

Chapter 30: Managed Futures: Strategies and Sources of Return

30.1 INVESTMENT STRATEGIES

30.2 ECONOMICS OF COMMODITY FUTURES MARKETS

30.3 EFFICIENT MARKET HYPOTHESIS AND RETURNS TO CTAs

30.4 PROFITABILITY OF MOMENTUM-BASED AND OTHER TREND-FOLLOWING STRATEGIES

30.5 EMPIRICAL EVIDENCE ON TECHNICAL TRADING RULES

30.6 CONCLUSION

Chapter 31: Risk and Performance Analysis in Managed Futures Strategies

31.1 RISK MEASUREMENT

31.2 HISTORICAL PERFORMANCE OF CTAs

31.3 RESEARCH ON PERFORMANCE AND BENEFITS OF MANAGED FUTURES

31.4 BENCHMARKING OF CTAs

31.5 ALPHA-BETA SEPARATION USING PASSIVE INDICES

31.6 PERFORMANCE OF CTAS DURING PERIODS OF FINANCIAL STRESS

31.7 CONCLUSION

Chapter 32: Structuring Investments in CTAs*

32.1 SOURCING MANAGERS

32.2 ISSUES IN STRUCTURING A CTA INVESTMENT PROGRAM

32.3 HOW MANY MANAGERS SHOULD ONE CHOOSE?

32.4 CTA FUNDS AND MULTI-CTA FUNDS

32.5 MANAGED ACCOUNTS

32.6 PLATFORMS

32.7 COMPARISON OF APPROACHES TO STRUCTURING A CTA INVESTMENT

32.8 QUANTITATIVE ANALYSIS OF MANAGERS

32.9 INVESTMENT AND OPERATIONAL DUE DILIGENCE PROCESSES

32.10 COST OF ACTIVE MANAGEMENT

32.11 CONCLUSION

CHAPTER 33: Hedge Fund Replication

33.1 INTRODUCTION

33.2 AN OVERVIEW OF REPLICATION PRODUCTS

33.3 POTENTIAL BENEFITS OF REPLICATION PRODUCTS

33.4 THE CASE FOR HEDGE FUND REPLICATION

33.5 UNIQUE BENEFITS OF REPLICATION PRODUCTS

33.6 FACTOR-BASED APPROACH TO REPLICATION

33.7 PAYOFF-DISTRIBUTION APPROACH

33.8 BOTTOM-UP OR ALGORITHMIC APPROACH

33.9 CONCLUSION

CHAPTER 34: Convertible Arbitrage

34.1 EVOLUTION OF THE CONVERTIBLE ARBITRAGE STRATEGY

34.2 TERMINOLOGY

34.3 VALUATION OF CONVERTIBLE SECURITIES

34.4 THE GREEKS

34.5 AN ARBITRAGE SITUATION

34.6 CONVERTIBLE ARBITRAGE IN PRACTICE: STRIPPING AND SWAPPING

34.7 LEVERAGE AND CONVERTIBLE ARBITRAGE

34.8 APPENDIX

CHAPTER 35: Global Macro and Currency Strategies

35.1 INTRODUCTION TO THE MACRO STRATEGIES

35.2 DIRECTIONAL CURRENCY TRADES

35.3 THE CASE OF EMERGING MARKETS

35.4 FOUR MODELS FOR CURRENCY TRADING

35.5 A MORE COMPLEX TRADE: CONTINGENT YIELD CURVE STEEPENING

35.6 RISK MANAGEMENT AND PORTFOLIO CONSTRUCTION

CHAPTER 36: Fundamental Equity Hedge Fund Strategies

36.1 VARIATIONS WITHIN EQUITY LONG/SHORT FUNDS

36.2 BACKGROUND OF THE LONG/SHORT EQUITY HEDGE FUND

36.3 MECHANICS OF THE STRATEGY

36.4 MANAGERIAL EXPERTISE AND SOURCES OF RETURNS

36.5 LONG/SHORT RETURN ATTRIBUTION

CHAPTER 37: Quantitative Equity Hedge Fund Strategies

37.1 VARIATIONS OF QUANTITATIVE STRATEGIES

37.2 BACKGROUND ON QUANTITATIVE STRATEGIES

37.3 MECHANICS OF QUANTITATIVE STRATEGIES

37.4 SOURCES OF RETURNS

37.5 A STYLIZED QUANTITATIVE EQUITY STRATEGY

37.6 THE GREAT QUANT MELTDOWN OF AUGUST 2007

CHAPTER 38: Funds of Hedge Funds

38.1 APPROACHES FOR ACCESSING HEDGE FUNDS

38.2 CHARACTERISTICS OF FUNDS OF HEDGE FUNDS

38.3 FUND OF FUNDS PERFORMANCE

38.4 FUND OF FUNDS PORTFOLIO CONSTRUCTION

38.5 MANAGER SELECTION

38.6 RISK MANAGEMENT

38.7 DUE DILIGENCE ISSUES ARISING IN THE CONTEXT OF FUNDS OF FUNDS

38.8 BENEFITS OFFERED BY FUNDS OF FUNDS

38.9 DISADVANTAGES OF FUNDS OF FUNDS

38.10 FUNDS OF FUNDS VERSUS INDIVIDUAL HEDGE FUNDS

38.11 HEDGE FUND INDICES

CHAPTER 39: Regulation and Compliance

39.1 A SUCCINCT HISTORY OF HEDGE FUND REGULATION IN THE UNITED STATES

39.2 REGISTRATION AND REGULATION IN THE UNITED STATES

39.3 VARIOUS REPORTING REQUIREMENTS FOR HEDGE FUNDS

39.4 THE GLOBAL REGULATORY ENVIRONMENT FOR HEDGE FUNDS

CHAPTER 40: Operational Due Diligence

40.1 OPERATIONAL DUE DILIGENCE

40.2 STRATEGY-SPECIFIC DUE DILIGENCE

References

Index

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Preface

Since its inception in 2002, the Chartered Alternative Investment Analyst (CAIA) Association has incorporated state-of-the-art reading materials into its curriculum. This latest curriculum reading represents a milestone in our efforts to continuously improve and update our curriculum. To ensure that the material best reflects current practices in the area of alternative investments, the CAIA Association invited a group of leading industry professionals to contribute to the production of the series, covering core areas of alternative investments: private equity, real assets, commodities, hedge funds, and managed futures. Similar to other books published by the CAIA Association, this book is grounded in the CAIA program's Core Knowledge Outline.

In publishing the books in this series, we are guided by the Association's mission to provide its members with a comprehensive knowledge of alternative investments, to advocate high standards of professional conduct, and to establish the Chartered Alternative Investment Analyst Charter as the educational gold standard for the alternative investment industry.

TEN YEARS OF CAIA AND ALTERNATIVE INVESTMENTS

The quality, rigor, and relevance of this series derive from the ideals on which the CAIA Association is based. After its founding in 2002, the first Level I examination was offered in February 2003, with the first Level II examination taking place in October 2003. I was privileged to be among the first class of 43 candidates who passed the Level I and Level II exams, met the other requirements of membership, and were invited to join the CAIA Association. Many of these founding members were instrumental in establishing the CAIA Charter as the global mark of excellence in alternative investment education. After just 10 years, we now have more than 5,700 members in 75 countries. Those who become members of the CAIA Association have the opportunity to network with other CAIA members, including attending events sponsored by CAIA's 15 chapters, located in financial centers worldwide.

The growth of CAIA, from 43 members to more than 5,700 members in 10 years, closely parallels the growth of the alternative investments industry. Preqin estimates that private equity assets in December 2002 were $767 billion, while closed-end private real estate assets under management (AUM) totaled just $81 billion. At the same time, Hedge Fund Research estimates that the hedge fund industry managed $625.5 billion. By 2011, assets across all alternative investment types had exploded, with hedge funds managing over $2,000 billion, private equity controlling nearly $3,000 billion, and private real estate investing over $500 billion. (See Exhibits P.1 and P.2). In 2003, infrastructure and commodity assets likely totaled less than $20 billion. While these asset classes were nascent in 2003, Preqin now estimates infrastructure assets at $174 billion, while Barclays estimates commodity assets at over $420 billion. In the past 10 years, entire asset classes have been created, with the first commodity exchange-traded fund being offered in November 2004; currently, commodity exchange-traded products hold over $200 billion in assets. Dry powder is the amount of assets controlled by, or committed to, closed-end funds that has not yet been invested by the fund manager. Larger amounts of dry powder indicate the amount of cash available to invest in the underlying assets, which leads some market participants to predict higher deal volume and asset valuation in the coming quarters.

EXHIBIT P.1 Growth of Private Equity Assets under Management (AUM) (in billions of dollars)

Source: Preqin Ltd.

EXHIBIT P.2 Growth of Closed-End Private Real Estate Assets under Management (AUM) (in billions of dollars)

Source: Preqin Ltd.

EXHIBIT P.3 Growth of CAIA Membership

Source: CAIA Association.

THE HISTORY OF CAIA

The CAIA Association was introduced to the investment community in 2002 by Florence Lombard, then Chief Executive Director of the Alternative Investment Management Association (AIMA), and Dr. Thomas Schneeweis, Director of the Center for International Securities and Derivatives Markets (CISDM). Ten years ago, together with a core group of academic and industry experts determined to fill an unmet need for a standard of education in this bourgeoning sector, they launched the CAIA Charter.

Like the sector of the industry it covers, the CAIA Association has grown rapidly. In 2008, the New York Society of Security Analysts recognized CAIA as the fastest-growing financial credential, and in the past three years alone, membership has more than doubled to more than 5,700. Fostered by a dedicated chapter relations team, the number of CAIA chapters has tripled to 15 from the first five chapters established in 2005; CAIA chapters now provide a platform for educational, career, and networking activities for thousands of alternative investments professionals in the world's major financial centers. CAIA now has six offices globally.

As the Association has grown, its program has evolved and advanced. In 2009, CAIA introduced the first editions of the most complete, authoritative desktop reference volumes on alternative investments ever created: CAIA Level I: An Introduction to Core Topics in Alternative Investments and CAIA Level II: Advanced Core Topics in Alternative Investments, written and edited exclusively by leading practitioners and academics. Now, in 2012, CAIA Association has published second editions of these volumes to keep pace with the latest strategies and information. Along with CAIA Level II: Core and Integrated Topics (which is revised annually to contain the most advanced material) and the Standards of Practice Handbook published by CFA Institute, these volumes round out a complete education in alternative investments for any finance professional.

CAIA has also continually provided ongoing educational resources to serve its growing member and candidate base. The suite of offerings includes the Journal of Alternative Investments, the official publication of the CAIA Association, and Alternative Investment Analyst Review, a digital research digest designed to make keeping abreast of the latest research easier. It also includes the member Self-Evaluation Tool and Member Library, designed to work together to help members stay current on the latest knowledge in alternative investments; multimedia content; educational and conference discounts; and more.

The Association formalized its commitment to advancing the alternative investment industry now and in the future by establishing the CAIA Foundation in 2011. The Foundation partners with sponsors to fund research and scholarships, raising the standard of knowledge and the talent pool in the alternative investment industry for the ultimate benefit of the investor.

BENEFITS OF THE CAIA PROGRAM

CAIA has become the leading-edge alternative investment credential and the unchallenged leading provider of education in alternative investments. Although the establishment of the CAIA Association was largely due to the efforts of professionals in the hedge fund and managed futures space, these founders correctly identified a void in the wider understanding of alternative investments as a whole. From the beginning, the CAIA curriculum has also covered private equity, commodities, and real assets, always with an eye toward shifts in the industry. Today, several hundred CAIA members identify their main area of expertise as real estate or private equity; several hundred more are from family offices, pension funds, endowments, and sovereign wealth funds that allocate across multiple classes within the alternative investment industry. Investment professionals in any asset class, such as real estate professionals, can benefit from a broad-based education in alternative investments, as it is important to see the big picture of institutional portfolios. An understanding of the investment goals and practices of institutional investors, including pensions, sovereign wealth funds, endowments, and foundations, is important for both institutional investors and managers of alternative investment products.

To accomplish this comprehensively, we have fully developed curriculum subcommittees that represent each area of coverage within the curriculum. All of these alternative investment areas share many distinct features, such as the relative freedom on the part of investment managers to act in the best interests of their investors, alignment of interests between investors and management, relative illiquidity of positions for some investment products, and deviations from some of the underpinning assumptions of modern portfolio theory. These characteristics necessitate conceptual and actual modifications to the standard investment performance analysis and decision-making paradigms.

Readers will find the publications in our series beneficial, whether from the standpoint of allocating to new asset classes and strategies in order to gain broader diversification or from the standpoint of a specialist needing to better understand the competing options available to sophisticated investors globally. In either case, readers will be better equipped to serve their clients' needs. The series has been designed to make studying more efficient relative to our past curriculum. Importantly, it is more relevant, having been written under the direction of the CAIA Association with the input and efforts of many practicing and eminent alternative investment professionals, as reflected in each publication's acknowledgments section.

STUDYING FOR THE CAIA EXAMS

“Foundations of the CAIA Curriculum” is an assessment tool for determining a candidate's readiness to enter the CAIA program. These foundational materials cover the quantitative analytics commonly associated with traditional assets, as well as a blend of practical and theoretical knowledge relating to both traditional and alternative investments.

The first book in our series, CAIA Level I: An Introduction to Core Topics in Alternative Investments, is a twice-revised edition of Mark Anson's Handbook of Alternative Assets. The CAIA Level I required readings are contained in this one text, supplemented only by the CFA Institute's Standards of Practice Handbook. Readers should be aware, however, that the Foundations program is important and that Level I candidates are assumed to have mastered all of the content in the Foundations guide in advance of taking the Level I exam.

The second book in our series, CAIA Level II: Advanced Core Topics in Alternative Investments, also represents a significant advancement in the coverage of our curriculum. The tools candidates develop in Level I of the CAIA program are applied in the Level II curriculum, which both integrates alternative investments into investor portfolios and presents risk management across asset classes. We believe this new model of curriculum development accurately reflects the skill set required of industry practitioners.

The third volume in this series is titled CAIA Level II: Core and Integrated Topics. It is updated annually and designed to address topics that cut across all areas of alternative investments, such as asset allocation and risk-management techniques, as well as new developments in the alternative investment research space and in the industry itself. This book is more frequently revised, which allows the Level II curriculum to rapidly adapt to new research trends in alternative investments as covered in academic and practitioner journals.

Finally, we will continue to update both the CAIA Level I Study Guide and the CAIA Level II Study Guide every six months (each exam cycle). These guides, available for free download at http://caia.org, outline all of the readings and corresponding learning objectives (LOs) that candidates are responsible for meeting. They also contain important information for candidates regarding the use of LOs, testing policies, topic weightings, where to find and report errata, and much more. The entire exam process is outlined in the CAIA Candidate Handbook and is available at http://caia.org/caia-program/exams/candidate-handbook.

I believe you will find this series to be the most comprehensive, rigorous, and globally relevant source of educational material available within the field of alternative investments.

It is my sincere wish that this volume contributes to the continuing growth of the alternative investments industry and, in particular, to the career growth of CAIA members and CAIA candidates.

KEITH H. BLACK, PhD, CFA, CAIA
Associate Director of Curriculum
CAIA Association
September 2012

Acknowledgments

We would like to thank the many individuals who played important roles in producing this book. Each section of this volume was developed by a set of main authors; however, several others were instrumental in bringing this project to its completion. Hossein Kazemi; Nelson Lacey; Donald R. Chambers, CAIA; and Kristaps Licis contributed greatly by providing and revising content in all sections, assisting with the development of the initial section outlines, which are based on the CAIA Core Knowledge Outline (CKO), and reviewing several section drafts. The following people were instrumental in bringing this project to its completion: Aaron Cunningham, CAIA; Brad Case, CAIA; Eliot Geller, CAIA; Hilary Till; James Bachman, CAIA; James Burron, CAIA; Jason Campbell, CAIA; Klaus Springer, CAIA; Robert Murphy, CAIA; Sam Gallo, CAIA; Sue Bannon, CAIA; Robert O'Donnell, CAIA; Jean Michaud; Christine Gaelzer; Thomas Schneeweis; and Timothy Peterson, CAIA.

Keith Black, CAIA, is the author of the first section on asset allocation and portfolio management. The main authors of the private equity section are Pierre-Yves Mathonet and Thomas Meyer. The main author of the real estate section is Donald R. Chambers, CAIA, with contributions from Mark Anson, CAIA. Chapters on timberland, farmland, and intellectual property were contributed by George Martin. The main author of the commodities section is Ed Szado, while chapters were also contributed by Moazzam Khoja, Zeno Adams, Roland Fuss, and Dieter Kaiser. Chapters on hedge funds and managed futures were authored by Hossein Kazemi, David McCarthy, Jim Liew, Susan Liew, and Keith Black, CAIA.

Finally, the second edition contains substantial content from the first edition of the book. Additional authors from the first edition include Urbi Garay, Ernest Jaffarian, Melissa Donohue, Richard Spurgin, Francois Lhabitant, and Simon Stevenson.

Importantly, we owe great thanks to Florence Lombard, Chief Executive Officer of the CAIA Association, and our committee members:

Curriculum Advisory Council

Mark Baumgartner

Jaeson Dubrovay, CAIA

David McCarthy

Armand van Houten, CAIA

Garry Crowder

James Tomeo

Daniel Celeghin

Angelo A. Calvello

Hedge Funds and Fund of Hedge Funds Committee

Solomon Tadesse

Jaeson Dubrovay, CAIA

Daniel Celeghin

Mark Hutchinson

Mark Wiltshire, CAIA

Real Assets Committee

Stephane Amara, CAIA

George A. Martin

Andreas Calianos

Tom Johnson, CAIA

Asif Hussain, CAIA

Commodities and CTAs Committee

Hamlin Lovell, CAIA

David McCarthy

Hilary Till

Joelle Miffre

Richard Spurgin

Private Equity Committee

Pierre-Yves Mathonet

Thomas Meyer

James Bachman, CAIA

Erik Benrud, CAIA

Gitanjali M. Swamy

Due Diligence and Regulation Committee

Jaeson Dubrovay, CAIA

Armand van Houten, CAIA

Tom Kehoe, CAIA

Hamlin Lovell, CAIA

Christopher Schelling, CAIA

Mark Wiltshire, CAIA

Asset Allocation, Risk Management, and Wealth Management Committee

Solomon Tadesse

Joelle Miffre

James T. Gillies, CAIA

Pierre Laroche

Structured Products Committee

Jon Rotolo

Samson Koo

CAIA Curriculum Group

Hossein Kazemi, PhD, CFA, Program Director

Donald Chambers, PhD, CAIA, Associate Director and Level I Manager

Keith Black, PhD, CFA, CAIA, Associate Director and Level II Manager

Jeanne Miller, Project Manager

Andrew Tetreault, Curriculum Assistant

Samantha Dodge, Editorial Consultant

Jamie Thaman, Editorial Consultant

About the Authors

Keith H. Black, PhD, CFA, CAIA, has over 20 years of financial market experience, serving approximately half of that time as an academic and half as a trader and consultant to institutional investors. He currently serves as Associate Director of Curriculum for the CAIA Association. During his most recent role at Ennis Knupp + Associates, he advised foundations, endowments, and pension funds on their asset allocation and manager selection strategies in hedge funds, commodities, and managed futures. Prior experience includes commodities derivatives trading at First Chicago Capital Markets, stock options research and Chicago Board Options Exchange (CBOE) market making for Hull Trading Company, and building quantitative stock selection models for mutual funds and hedge funds for Chicago Investment Analytics. Dr. Black previously served as an assistant professor and senior lecturer at the Illinois Institute of Technology's Stuart School of Business, where he taught courses in both traditional and alternative investments.

He contributes regularly to the CFA Digest, and has published in the Journal of Global Financial Markets, the Journal of Trading, the Journal of Financial Compliance and Regulation, the Journal of Investing, the Journal of Environmental Investing, and Derivatives Use Trading and Regulation. He is the author of the book Managing a Hedge Fund. Dr. Black was named to Institutional Investor magazine's list of “Rising Stars of Hedge Funds” in 2010.

Dr. Black earned a BA from Whittier College, an MBA from Carnegie Mellon University, and a PhD from the Illinois Institute of Technology. He has earned the Chartered Financial Analyst (CFA) designation and was a member of the inaugural class of the Chartered Alternative Investment Analyst (CAIA) candidates.

Donald R. Chambers, PhD, CAIA, is Associate Director of the Level 1 Curriculum at CAIA and is the Walter E. Hanson KPMG Professor of Finance at Lafayette College in Easton, Pennsylvania. He has published 50 articles and numerous books on investments, corporate finance, and risk management. He received a PhD in finance from the University of North Carolina at Chapel Hill and a BS in accounting from SUNY–Binghamton.

Dr. Chambers previously served at the University of Baltimore, Rochester Institute of Technology, Pennsylvania State University, and University of North Carolina at Chapel Hill. He served at Karpus Investment Management as Director of Alternative Investments. Dr. Chambers earned the CAIA designation in September 2003 as a member of the first group of candidates to complete the requirements.

Hossein Kazemi, PhD, CFA, is the Program Director for the CAIA Association. He oversees the development, execution, and analysis of the CAIA program's curriculum and examinations. Dr. Kazemi is one of co-founders of the CAIA Association. In addition, he has worked with universities and industry organizations to introduce them to the CAIA program. Dr. Kazemi is a professor of finance at the Isenberg School of Management at the University of Massachusetts, Amherst. Dr. Kazemi is currently an Associate Director of the Center for International Securities and Derivatives Markets, a nonprofit organization devoted to research in the area of alternative investments, a co-founder of the CAIA Association, and home to CISDM Hedge Fund/CTA Database. He was involved in the development of first investable hedge fund indices as well. He is an associate editor of the Journal of Alternative Investments. His research has been in the areas of valuations of equity and fixed-income securities, asset allocation for traditional and alternative asset classes, and evaluation and replication of active management investment products. He has a PhD in finance from the University of Michigan.

Mark J.P. Anson, PhD, CAIA, is a Managing Partner at Oak Hill Investment Management, LP. Dr. Anson previously served as President and Executive Director of Investment Services at Nuveen Investments, Chief Executive Officer at Hermes Pension Management Limited, and Chief Investment Officer at California Public Employees' Retirement System. He has published over 100 research articles in professional journals, has won two “Best Paper” awards, is the author of six financial textbooks, and sits on the editorial boards of several financial journals.

Galen Burghardt, PhD, is Senior Director of Research for Newedge USA, LLC, a joint venture between Calyon and Societe Generale. He is the lead author of The Treasury Bond Basis and The Eurodollar Futures and Options Handbook, which are standard texts for users of financial futures. His latest book, written with Brian Walls, is Managed Futures for Institutional Investors: Analysis and Portfolio Construction (Bloomberg/Wiley, 2011). He was an adjunct professor of finance in the University of Chicago's Graduate School of Business (now the Booth School). He was the head of financial research for the Chicago Mercantile Exchange, and gained access to the world of futures through his work in the Capital Markets Section of the Federal Reserve Board. His PhD in economics is from the University of Washington in Seattle.

Francois-Serge Lhabitant, PhD, is currently the CEO and CIO of Kedge Capital, where he runs more than $6.5 billion invested in hedge fund strategies. He was formerly a member of senior management at Union Bancaire Privée, where he was in charge of quantitative risk management and subsequently of quantitative analysis for alternative portfolios. Prior to this, Dr. Lhabitant was a Director at UBS/Global Asset Management, in charge of building quantitative models for portfolio management and hedge funds. On the academic side, he is currently a professor of finance at the EDHEC Business School (France) and a visiting professor at the Hong Kong University of Science and Technology.

Jim Liew, PhD, is the CEO of JKL Capital Management, LLC. He is also an adjunct professor of finance at New York University Stern School of Business, where he teaches the course Hedge Fund Strategies. Dr. Liew also taught the course Statistical Arbitrage at Columbia, Baruch, and Johns Hopkins. Previously, he worked at a large macro quant fund and at an ultrahigh-frequency statistical arbitrage fund, where he built, backtested, and implemented systematic investment strategies.

Dr. Liew has extensive business experience within the fund-of-funds industry, which includes starting a successful hedge-fund-of-funds business that eventually spun out of the Carlyle Group, managing the World Bank's pension fund direct investments into hedge funds, and sourcing hedge funds and creating institutional investment products at a well-known managed account platform. He has published numerous articles on hedge fund investing and quantitative investment strategies. Dr. Liew currently consults and advises hedge funds, individuals, and institutions on alternative investment opportunities.

Dr. Liew obtained his PhD in finance from Columbia Business School. He currently serves on the Editorial Advisory Board of the Journal of Portfolio Management.

Susan Liew, JD, served as the Chief Compliance Officer at Calypso Capital Management, LLC. Mrs. Liew is admitted to practice in New York.

George A. Martin is an associate director at the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts at Amherst. He is also a member of the Real Assets Curriculum Subcommittee of Chartered Alternative Investment Analyst (CAIA) Association and an editorial board member of the Journal of Alternative Investments. As part of his research endeavors, he has published a large number of papers on alternative assets, including hedge funds, commodities and real assets, and is a frequent speaker on such subjects. He is also commercially active, as a principal at Alternative Investment Analytics, LLC, and as Senior Advisor to Wood Creek Capital Management, an asset management firm that specializes in real assets. Previously, he was a research fellow at the Brookings Institution. He has BA and MA degrees from Johns Hopkins University. 

Pierre-Yves Mathonet is head of the private equity risk management division of the European Investment Fund. He is a permanent member of the private equity subcommittee of the Chartered Alternative Investment Analyst Program and of the Risk Measurement Guidelines working group of the European Private Equity and Venture Capital Association (EVCA). He is also co-directing the Certificate in Institutional Private Equity Investing (CIPEI) course held by the Oxford Said Business School's Private Equity Institute. Before that, he worked as an investment banker in the technology groups of Donaldson, Lufkin & Jenrette and Credit Suisse First Boston and, previously, for the audit and consulting departments of PricewaterhouseCoopers.

Pierre-Yves co-authored several books, including Beyond the J-Curve and J-Curve Exposure. He holds a master of science cum laude in finance from London Business School and a master of science magna cum laude in management from Solvay Business School in Brussels. He is also a Certified European Financial Analyst cum laude.

David F. McCarthy, PhD, is the Principal of D.F. McCarthy LLC, a consulting and advisory firm. In 2002, he co-founded Martello Investment Management, LP, a specialist fund of funds and advisory firm concentrating on absolute return hedge fund strategies, including global macro and commodity trading adviser (CTA) strategies. From 1994 to 2000, Dr. McCarthy was an investment manager for Global Asset Management (GAM), where he managed GAM's trading funds of funds. He has been an investment officer with the Atlantic Philanthropies, a partner in Rayner and Stonington, a deputy manager of the International Financial Advisory Service of Brown Brothers Harriman & Co., and a consultant with McKinsey & Co. Dr. McCarthy is a faculty member of Fordham University in New York and University College Cork in Ireland. He is a contributor to the Greenwich Roundtable “Best Practices in Hedge Fund Investing” series, and is the author of a number of academic articles on managed futures. He holds a PhD from University College Dublin, an MBA from Stanford University, and a BA from the University of New Hampshire.

Thomas Meyer is a co-founder of LDS Partners, an advisory firm providing solutions for liquidity, portfolio, and risk management for institutional investors in private equity funds. After 12 years in the German Air Force, Thomas worked for the German insurance group Allianz AG in corporate finance and as the regional chief financial officer of Allianz Asia Pacific in Singapore. He was responsible for the creation of the risk management function at the European Investment Fund. He is a Shimomura Fellow of the Development Bank of Japan and was a visiting researcher at Hitotsubashi University in Tokyo and a director of the European Private Equity and Venture Capital Association. Dr. Meyer is co-directing the Certificate in Institutional Private Equity Investing (CIPEI) course held by the Oxford Said Business School's Private Equity Institute. He is a member of the private equity subcommittee of the Chartered Alternative Investment Analyst Program and co-authored a series of books (e.g., Beyond the J-Curve and J-Curve Exposure).

Edward Szado, PhD, CFA, is the Director of Research of the Institute for Global Asset and Risk Management (INGARM) and a research associate at the Center for International Securities and Derivatives Markets (CISDM). He has a PhD (ABD) in finance at the Isenberg School of Management, University of Massachusetts, Amherst. He is at present a coeditor of the Alternative Investment Analyst Review and an assistant editor of the Journal of Alternative Investments. He has taught corporate finance, bank management, and risk management at the Isenberg School of Management, University of Massachusetts, Amherst, and the Graduate School of Management, Boston University. He is a former options trader, and his experience includes product development in the areas of volatility-based investments and structured investment products. He is also a Chartered Financial Analyst and has consulted for the Options Industry Council, the Chicago Board Options Exchange, the Chartered Alternative Investment Analyst Association, and the Commodity Futures Trading Commission. His publications include articles in the Journal of Alternative Investments, the Journal of Trading, the Journal of Investing, Alternative Investment Analyst Review, Alternative Investment Quarterly, Journal of Investment Consulting, and the Investments and Wealth Monitor.

Brian Walls is the Global Head of Research at Newedge Alternative Investment Solutions, the foremost provider of brokerage services to the managed futures industry. He has worked in the financial services industry for 30 years in the various capacities of trading, operations, management, and research. He was a pioneer of capital introduction services and is a sought after and trusted adviser to many commodity trading advisers, global macro managers, fund of funds, and institutional investors. He is the chairman of the Newedge Index Committee. Brian is the co-author, with Galen Burghardt, of Managed Futures for Institutional Investors: Analysis and Portfolio Construction, published by John Wiley & Sons in April 2011.

CHAPTER 1

Introduction

This second edition of CAIA Level II: Advanced Core Topics in Alternative Investments represents a substantial revision of the first edition. The topics covered are as dynamic as the alternative investments industry itself, as every textbook underlying the CAIA program adapts to growth in the industry and emerging asset types. Although the private equity and hedge fund parts closely follow those of the previous edition, material on managed futures, commodities, and real estate has been substantially revised. Across most topic areas, coverage on due diligence, liquidity risk, and operational due diligence has been enhanced. The importance of currency markets in global investing is directly addressed in a commodity context as well as within the framework of global macro hedge funds.

1.1 OUTLINE OF THIS BOOK

The book is divided into five parts. The first part discusses endowments, foundations, and pension plans as examples of institutional investors. The final four parts each discuss a sector of alternative investment strategies: private equity, real assets, commodities, and hedge funds and managed futures.

Part One of the book discusses asset allocation and portfolio management from the point of view of institutional investors. Completely new to the second edition are Chapters 2, 3, and 4, which outline the investment challenges and practices of endowments, foundations, and pension plans, which have become some of the world's largest investors in alternative assets. These chapters explore the motivation for those investors to grow their asset allocation to alternative investments. They face special risks and considerations when investing in alternative assets and integrating those assets into their business operations. These include spending rates, inflation, liquidity, rebalancing, tail risk, funding status, and surplus risk. The endowment model as represented by the investment strategy of Yale University's endowment is examined in Chapter 2, while liability-driven investing is a highlight of Chapter 4.

Part Two, which comprises Chapters 5 to 14, discusses the private equity market. Building on the material from CAIA Level I: An Introduction to Core Topics in Alternative Investments, it covers advanced topics in private equity investments and describes various routes into those investments. It explains manager selection and monitoring processes; reviews benchmarking in the private equity world, valuation methods, and management of liquidity; explains substrategies of private equity, including buyouts, venture capital, and mezzanine financing. The roles of the general partner and limited partners are outlined, as are the risks that arise in these relationships. This part explores private equity portfolio design through direct investments in funds, co-investments, funds of funds, and secondary investments. The important role of the vintage year is discussed in terms of both liquidity management and diversification.

Part Three presents real assets, including real estate, farmland, timber, and intellectual property investments. Real assets are considered desirable assets because of their potential to provide a hedge against inflation risk. Three chapters in this section, Chapter 16: Unsmoothing of Appraisal-Based Returns, Chapter 21: Farmland and Timber Investments, and Chapter 22: Investing in Intellectual Property, are new to this edition. The Level I book discussed real estate investments in terms of the underlying equity or debt structure. This book divides real estate into publicly traded and private partnership investments, as well as risk characterizations including investments in core, value-added, and opportunistic properties. Various forms of real estate investment and valuation methodologies are discussed, as is the due diligence of real estate investments and the risk-return characteristics of major real estate indices. Of special interest is Chapter 16, which contains all-new material on the unsmoothing of real estate returns. Illiquid assets tend to have return processes that are too smooth, which leads to biases in their risk estimation. Because appraisal-based returns, whether in real estate or in private equity, are not what they seem, investors need to make quantitative adjustments to smoothed returns to calculate more accurate risk exposures before adding these investments to their portfolios. Reflecting the market's dramatic growth in real asset investments, Chapters 21 and 22 have been added to discuss investments in farmland, timber, and intellectual property.

Part Four discusses commodities with a focus on commodity investments through futures and swaps markets. The role of hedgers and speculators is explored, along with how each might impact the term structure of futures prices. The readings provide advanced analysis of commodity markets and explain the role of commodities in asset allocation. This part describes various methods for generating commodity alpha and beta through spot and futures transactions and discusses major commodity indices and their risk-return profiles. The role of fundamental demand and supply factors is explored, as well as the financial market drivers of commodity returns, including linkages to currency markets, interest rates, inflation, and the business cycle. Risk management of commodity strategies is also included, with studies in liquidity risk and event risk management.

The final section, Part Five, discusses hedge funds and managed futures. The first four chapters, 29 to 32, cover managed futures strategies. The structure of the managed futures industry and its regulatory framework are presented, and each managed futures strategy and its risk-return profile are explained. The role of managed futures in diversified portfolios is examined, and performance evaluation and manager selection processes are explained. The distinctions between single-manager and multimanager funds, separate accounts, and platform investments are discussed, which can have important implications for performance, fees, and legal risks. In light of the collapse of MF Global, the importance of collateral segregation is emphasized. Risk measurement and control are presented, and the importance of margin-to-equity ratios is discussed.

Finally, Chapters 33 to 40 discuss investments in hedge funds. New to this edition is Chapter 33, which explores the theory and practice of hedge fund replication and factor modeling. Chapters 34 to 37 discuss specific hedge fund strategies, including convertible arbitrage, global macro, and long/short equity. Foreign currency strategies are examined and their benchmarks are evaluated. The risk-return characteristics of funds of funds and investable hedge fund indices are explained and compared. Due diligence processes for various hedge fund strategies and the role of operational risk are explained. Hedge fund replication products are presented, and various methodologies used in the creation of these products are evaluated. A detailed examination of the global macro strategy is also presented, with examination of the potential role of this strategy in the presence of increased uncertainty in the global markets. Portfolio construction of funds of funds is studied along with the benefits and costs of investing in multimanager products.

1.2 STUDYING FOR THE CAIA LEVEL II EXAMINATION

The reading materials for the CAIA Level II examination include the CFA Institute's Standards of Practice Handbook, this volume: CAIA Level II: Advanced Core Topics in Alternative Investments, and CAIA Level II: Core and Integrated Topics. The syllabus for the exam, which outlines all of the readings and corresponding learning objectives (LOs) that candidates are responsible for meeting, is contained in the CAIA Level II Study Guide, which is available for free download at http://caia.org. This document also contains important information for candidates regarding the use of LOs, testing policies, topic weightings, where to find and report errata, and much more. The entire exam process is outlined in the CAIA Candidate Handbook and is available at http://caia.org/caia-program/exams/candidate-handbook.

PART One

Asset Allocation and Portfolio Management

CHAPTER 2

The Endowment Model

Investors allocating assets to alternative investments need a framework on which to build their portfolios. What should the size of the allocation to traditional investments be, relative to alternative investments? Within alternative investments, how should the portfolio be diversified across asset classes, styles, and managers? For many, the answers come from a study of the investment practices of the managers of the largest endowment and foundation portfolios.

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